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Interbank Networks in the Shadows of the Federal Reserve Act

with Haelim Anderson, Guillermo Ordoñez
Revise and Resubmit, Review of Economic Studies , 2022
Elsevier Best Paper on Financial Institutions, Western Finance Association, 2020
The establishment of the Federal Reserve System (i) led to the emergence of the first shadow banking system, (ii) increased locally concentrated borrowing, and (iii) introduced new risks through reliance on short-term borrowing and public liquidity pass-through.

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).

Network Hazard: Resilience and Moral Hazard in Network Formation

New Version, Submitted , 2024
More effective tools to mitigate contagion paradoxically increase contagion and volatility, and reduce welfare and resilience.

I develop a novel framework for studying network formation with continuum populations. I use the framework to examine contagion and resilience in endogenous networks, with applications to misinformation, supply chains, financial contagion, and epidemics. I examine the equilibrium effects of policies that mitigate contagion externalities and find that interconnectedness and concentration increase in response to interventions. This general equilibrium response negates the benefits of interventions and creates a “network hazard.” Despite interventions that mitigate contagion ex post, contagion and volatility are exacerbated and welfare and resilience are reduced ex ante.

Network Formation and Systemic Risk

with Rakesh V. Vohra
European Economic Review , 148: 104213, 2022
Endogenous financial networks can develop core-periphery structures despite ex-ante homogeneity, inherently giving rise to the volatility paradox where improved fundamentals lead to increased tail risks.

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.

Relationship Externalities

with Rakesh V. Vohra
Journal of Economic Theory , 206: 105567, 2022
Stable and efficient networks are characterized in a framework where agents face positive or negative spillovers originating from the connections in the network, not only spillovers originating from the agents spread through the connections.

We propose a model of network formation where agent’s payoffs depend on the connected component they belong to in a way that is specific enough to be tractable yet general enough to accommodate a number of economically relevant settings. Among them are formation in the presence of contagion via links and collaboration with spillovers. A key feature of this setting is that the externalities stem from links rather than nodes. We characterize stable and efficient networks. Under negative externalities, disjoint cliques are stable and efficient. Under positive externalities complete networks and star networks are stable. Efficient networks feature a mix: pineapple networks which consist of one large clique and a star network appended to each other.

Network Reactions to Banking Regulations

with Guillermo Ordoñez
Journal of Monetary Economics , 89: 51-67, 2017
The network of bilateral relationships that facilitate liquidity sharing between banks is subject to a tipping point with respect to liquidity requirements, beyond which the network collapses.

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

with Michael Junho Lee
2nd Revise and Resubmit, Journal of Economic Theory , 2023
Effective regulation of insider trading necessitates regulatory ambiguity, as insiders can outcompete regulators by exploiting economies of scale, and outsourcing obfuscation and “gaming” to a centralized group that acts as conduits between tippers and tippees.

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.

Civil Liberties and Social Structure

with Camilo García-Jimeno
Revise and Resubmit, Journal of Economic Theory , 2023
Oppressive regimes that surveil societies to thwart potential threats while avoiding public backlash employ a “divide and conquer” strategy, discriminating against one (payoff-irrelevant) group and exploiting trust in another, even amidst evolving social structures.

Governments use coercion to aggregate distributed information relevant to governmental objectives –from the prosecution of regime-stability threats to terrorism or epidemics–. A cohesive social structure facilitates this task, as reliable information will often come from friends and acquaintances. A cohesive citizenry can more easily exercise collective action to resist such coercion, however. We present an equilibrium theory where this tension mediates the joint determination of social structure and civil liberties. We show that segregation and unequal treatment sustain each other as coordination failures: citizens choose to segregate along the lines of an arbitrary trait only when the government exercises unequal treatment as a function of the trait, and the government engages in unequal treatment only when citizens choose to segregate based on the trait. We characterize when unequal treatment against a minority or a majority can be sustained, and how equilibrium social cohesiveness and civil liberties respond to the arrival of widespread surveillance technologies, shocks to collective perceptions about the likelihood of threats or the importance of privacy, or to community norms such as codes of silence.

Network Hazard and Bailouts

2019
Best Job Market Paper Runner-up prize, Finance Theory Group, 2016
Implicit bailout guarantees can cause core-periphery networks to become self-reinforcing, possibly even self-fulfilling, undermining the intended purpose of bailouts.

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.

Network Hazard and Superspreaders

with Musa Eren Celdir
2023
More vaccinations led to more infections during the Covid-19 pandemic, mediated through increased foot traffic.

Higher availability and efficacy of protective measures against infectious diseases, such as vaccines, increases individuals’ propensity to socialize. Consequently, the number of visits to central points of interest (e.g., schools, gyms, grocery stores) and the rate of interactions with the agents employed therein (e.g., teachers, trainers, cashiers) increase. This opens more channels for the virus to transmit through the central agent or location. This leads to a manifestation of network hazard (Erol 2019). The infection rates can increase as protective measures become more effective and more available. Testable predictions of the theory are confirmed by the foot traffic data from 2019-2022 and historical COVID-19 vaccination and community transmission rates.

Social and Economic Distancing

with Guillermo Ordoñez
2020
The Covid-19 pandemic may have resolved a social coordination problem that previously hindered the adoption of more efficient remote work arrangements.

Dealing with pandemics, such as the recent COVID-19 virus, has highlighted the critical role of social distancing to avoid contagion and deaths. New technologies that allow replacing in-person for at-distance activities have blurred the mapping between social and economic distancing. In this paper we model how individuals react to social distancing guidelines by changing their network of economic relations, affecting total output, wealth inequality, and long-term growth.

Strong Stability and Contagion