Selman Erol
Tepper School of Business, Carnegie Mellon University
Working papers
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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).
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.
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.
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.
Civil Liberties and Social Structure
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.
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.
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.
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.
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.