Systemic Risk

Abstract

This chapter presents a model of the inter-bank payment based on a similar model proposed by McAndrews and Wasilyew (MW) (1995), and of a type frequently used by researchers and policy-makers to justify concerns about systemic risk in the inter-bank payment system. We find that MW’s conclusion, that systemic risk increases with the size of the banking industry, the likelihood of bank exchange, and the possible size of bank payments, is flawed. We modify the model by adding a distribution of bank sizes, enforcing the payments of loans to defaulting banks and selling loans to defaulting banks at a discount. Our results show that each of these reasonable modifications substantially affects the probability of systemic crisis in the event of bank failure. Further modification of the model to account for loan distribution indicates that systemic risk decreases with both the overall size of the banking industry and the likelihood of payment exchange. Our results suggest that there is no systemic risk in a heavily integrated and minimally regulated banking system.