TAILIEUCHUNG - Financial fragility and interbank structure

This paper follows Allen and Gale (2000) to model financial contagion as an equilibrium phenomenon. I assume a two-country economy where banks in each country hold interregional claims on other banks to provide insurance against liquidity preference shocks. The results replicate Allen-Gale model. | http afr. Accounting and Finance Research Vol. 7 No. 3 2018 Financial Fragility and Interbank Structure Yalan Feng1 1 College of Business and Economics California State University Los Angeles Correspondence Yalan Feng Department of Finance and Law CBE Simpson Tower California State University Los Angeles Los Angeles CA 90032 USA. Tel 1-323-343-2863. E-mail yfeng10@ Received February 14 2018 Accepted June 14 2018 Online Published June 25 2018 doi URL https Abstract This paper follows Allen and Gale 2000 to model financial contagion as an equilibrium phenomenon. I assume a two-country economy where banks in each country hold interregional claims on other banks to provide insurance against liquidity preference shocks. The results replicate Allen-Gale model. To further test the relative robustness of different market structures I test the implication of moral hazard as in Brusco and Castiglionesi 2007 . I find that under certain situation complete and incomplete structures are equally fragile. Keywords interbank structure financial fragility financial contagion 1. Introduction Following the subprime mortgage crisis originated in the US the country s whole financial sector had been in crisis. Moreover the crisis spread to countries that did not appear to have common economic fundamentals as the US. Banks provide liquidity in the financial markets while being exposed to the risk of bank runs Diamond and Dybvig 1983 . When bank runs occur they spread across institutions and countries See Schmidt Timmermann and Wermers 2015 and Covitz Liang and Suarez 2013 . One of the leading explanations is the interbank connections studies by Allen and Gale 2000 and Freixas Parigi and Rochet 2000 . These studies find that the architecture of the system of cross-holding is influential in the system fragility. More specifically a complete system where each bank borrows from and lends to all other banks is less

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