Selman Erol
Tepper School of Business, Carnegie Mellon University
financial networks
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Interbank Networks in the Shadows of the Federal Reserve Act
Central banks provide public liquidity (through lending facilities and promises of bailouts) with the intent to stabilize the financial system. Even though this provision is restricted to member (regulated) banks, an interbank system can provide indirect access to nonmember (shadow) banks. We construct a model to understand how a banking network may change in the presence of central bank interventions and how those changes affect financial fragility. We provide evidence showing that the introduction of the Fed’s liquidity provision in 1913 increased systemic risk through three channels; it reduced aggregate liquidity, created a new source of financial contagion, and crowded out private insurance for smoothing cross-regional liquidity shocks (manifested through the geographic concentration of networks).
Regulating Clearing in Networks
Recent U.S. and European regulations promote centrally clearing derivatives to reduce complexity and systemic risk in the financial system. With a network model, we show that their effectiveness depends on clearing patterns. More clearing does not guarantee less systemic risk. Systemic risk can increase if multilateral netting increases at the expense of bilateral netting. We study confidential derivatives regulatory data and find evidence that contagion is less likely to start in the core but more likely to spread from the core. We introduce concepts of complexity and centrality within the financial network, exploring their implications for stability and regulatory oversight.
Financial System Architecture and Technological Vulnerabilities
This paper presents a framework to study of technological resiliency of financial system architecture. Financial market infrastructures, or platforms, compete with services critical functions along various stages in the lifecycle of a trade, and make investments in technological resiliency to guard against attackers seeking to exploit system weaknesses. Platforms’ financial network effects attenuate competition between platforms on security. Exposure to vulnerabilities is magnified in the presence of strategic adversaries. Private provision of technological resiliency is generally sub-optimal, with over- and underinvestment in security depending on market structure. Vulnerabilities evolve over the maturity of a financial system, but there generically exists a tipping point at which technological resiliency diverges from optimal and creates technological drag on the financial system. We find supportive evidence in tri-party repo settlement: the exit of duopolist resulted in a significant drop in IT-related investment by the sole provider, even as peer firms ramp up investment.
This paper introduces a model of endogenous network formation and systemic risk. In it, firms form joint ventures called ‘links’ which are subsequently subjected to either good or bad shocks. Bad shocks incentivize default. Links yield full benefits only if the counter-party does not subsequently default on the project. Accordingly, defaults triggered by bad shocks render firms insolvent and defaults propagate via links. The model yields three insights. First, stable networks with ex-ante identical agents exhibit a core–periphery structure. Second, an increase in the probability of good shocks increases systemic risk. Third, because the network formed depends on the correlation between shocks to links, an observer who misconceives the correlation will underestimate the probability of system-wide default by a factor of a half.
Optimal regulatory restrictions on banks have to solve a delicate balance. Tighter regulations reduce the likelihood of banks’ distress. Looser regulations foster the allocation of funds toward productive investments. With multiple banks, optimal regulation becomes even more challenging. Banks form partnerships in the interbank lending market in order to face liquidity needs and to meet investment possibilities. We show that the interbank network can suddenly collapse when regulations are pushed beyond a critical level, with a discontinuous increase in systemic risk as the cross-insurance of banks collapses.
Insider Networks
How do insiders respond to regulatory oversight on the use of insider information? History suggests that they form more sophisticated networks to circumvent regulation. We develop a theory of the formation and regulation of insider information networks. We show that agents with sufficiently complex networks bypass any given regulatory environment. In response, regulators employ broad regulatory boundaries to combat gaming. Tighter regulation induces agents to migrate activity from existing social networks to a core-periphery insider network. A small group of agents endogenously arise as intermediaries for the bulk of transmissions.
This paper studies a model of firms with endogenous bilateral exposures and government bailouts. It is shown that the anticipation of bailouts makes firms less concerned with the counterparty choices of their counterparties. This “network hazard” gives rise to large central firms. Bailouts can mitigate contagion but they can not restore output losses. Consequently, idiosyncratic bad shocks to large central firms generate large welfare losses. As such, bailouts create welfare volatility and systemic risk. Surprisingly, moral hazard on risk-return dimension is mitigated by bailouts. Ex-ante regulations can induce discontinuous changes in the network.
During the 1920-1921 recession, the Richmond Fed provided liquidity to its member banks to prevent a banking crisis. Using newly digitized data on interbank borrowing and deposits for Virginia state banks, we analyze how the Richmond Fed’s liquidity provision affected the interactions between the funding role and the payment role of the interbank system and financial stability. We show that the Richmond Fed’s liquidity provision enabled members to lend discount window liquidity to nonmembers that experienced large deposit outflows and prevented the mass withdrawal of interbank deposits. Interestingly, the banks with interbank borrowing reduced interbank deposits placed in lending banks, implying that these correspondents provided liquidity to nonmembers through both interbank loans and deposits. Our study shows that understanding the interaction between different types of networks is important to promote the stability of the banking system.