Endogenous network topology in the interbank lending market

Hosted by Marco Faravelli

In this paper we introduce a model of interbank trading with endogenous network formation. Given an initial level of capitalization and a distribution of survival probability for banks in the banking system, the necessity of forming linkages among institutions steam from the occurrence of idiosyncratic liquidity shocks. Banks choose potential counterparties in order to reduce the risk of default through bilateral agreements.

In this setting, we show that a financial network, which allows losses to be shared among various trading partners, arises endogenously and that the increase of the probability of systemic risk in an equilibrium interbank network can be explained by the trading decisions of banks. As it turns out, with heterogeneous agents, inequalities in the initial endowments of banks can lead to large payoff differentials because of the endogenous network structure.

The model reproduces well features of trading decisions observed empirically in a real market for overnight interbank deposits.