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Rollover risk and endogenous network dynamics

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Abstract

Using a dynamic network formation model, solved numerically, we study banks’ rollover decisions. We find that when the existence of linkages between market participants generates an informational externality, the newly formed network is conditioned by past architectures. Moreover, this inertia is strongly dependent on macroeconomic conditions, such as investors’ risk appetite. Simulations show that for intermediate values of the risk appetite’s parameter the financial network exhibits tipping points, i.e., the inability to maintain a threshold number of linkages may push the market into a gridlock. In this context, we study also how policy instruments, such as taxes and subsidies, affects debt rollover. Since a reduction in the policy level plays the same role as an improvement in economic fundamentals, the creation of interbank connections can be stimulated by it. Thus, in order to restart lending after a major stress situation in the interbank market a considerable reduction in the policy level is required, advising a counter-cyclical policy similar to the ones recently proposed with respect to capital requirements.

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Notes

  1. We can think about this setup as a second stage of a broader game where borrowers offer a refinancing contract based on the rollover decisions of the lenders. However, this extension is left for future research.

  2. In the special case in which random variables are jointly normally distributed, linear least-squares projections equal conditional expectations.

  3. For a more complete distinction between risk aversion and appetite see Gai and Vause (2006).

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Acknowledgments

The first author acknwoledges financial support from FCT Ph.D. scholarship SFRH/BD/62309/2009.

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Authors and Affiliations

  1. Department of Economics, Indiana University Bloomington, Bloomington, Indiana, 47405, USA

    Jose Fique & Frank Page

  2. Centre d’Economie de la Sorbonne, Universite Paris 1, Pantheon-Sorbonne, 75647 , Paris Cedex 13, France

    Frank Page

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  1. Jose Fique
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  2. Frank Page
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Correspondence to Jose Fique.

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Fique, J., Page, F. Rollover risk and endogenous network dynamics. Comput Manag Sci 10, 213–230 (2013). https://doi.org/10.1007/s10287-013-0172-8

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