Systemic risk through contagion in a core-periphery structured banking network

TL;DR

This paper models systemic risk in a core-periphery banking network using a vector Ornstein-Uhlenbeck process, revealing how inhomogeneity influences contagion and risk management in interbank markets.

Contribution

It introduces a simple yet realistic network model of interbank markets and proves a law of large numbers and propagation of chaos for large networks.

Findings

Inhomogeneity affects contagion risk levels.

The model captures core-periphery structure better than homogeneous models.

Results inform risk management strategies in banking networks.

Abstract

We contribute to the understanding of how systemic risk arises in a network of credit-interlinked agents. Motivated by empirical studies we formulate a network model which, despite its simplicity, depicts the nature of interbank markets better than a homogeneous model. The components of a vector Ornstein-Uhlenbeck process living on the vertices of the network describe the financial robustnesses of the agents. For this system, we prove a LLN for growing network size leading to a propagation of chaos result. We state properties, which arise from such a structure, and examine the effect of inhomogeneity on several risk management issues and the possibility of contagion.