Incentivizing resilience in financial networks

Leduc, M.V. & Thurner, S. (2016). Incentivizing resilience in financial networks. SSRN Electronic Journal 1-37.

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When banks extend loans to each other, they generate a negative externality in the form of systemic risk. They create a network of interbank exposures by which they expose other banks to potential insolvency cascades. In this paper, we show how a regulator can use information about the financial network to devise a transaction specific tax based on a network centrality measure that captures systemic importance. Since different transactions have different impact on creating systemic risk, they are taxed differently. We call this tax a Systemic Risk Tax (SRT). We show that this SRT induces a unique equilibrium matching of lenders and borrowers that is systemic risk efficient, i.e. it minimizes systemic risk given a certain transaction volume. On the other hand, we show that without this SRT multiple equilibrium matchings can exist and are generally inefficient. This allows the regulator to effectively ‘rewire’ the equilibrium interbank network so as to make it more resilient to insolvency cascades, without sacrificing transaction volume. Moreover, we show that a standard financial transaction tax (e.g. a Tobin-like tax) has no impact on reshaping the equilibrium financial network because it taxes all transactions indiscriminately. A Tobin-like tax is indeed shown to have a limited effect on reducing systemic risk while it decreases transaction volume.

Item Type: Article
Uncontrolled Keywords: systemic risk, interbank networks, nnsolvency, cascades, network formation, matching markets, transaction-specific tax, market Design
Research Programs: Advanced Systems Analysis (ASA)
Depositing User: Romeo Molina
Date Deposited: 27 Jun 2016 09:08
Last Modified: 27 Aug 2021 17:27

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