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Abstract
This paper studies a model in which banks decide on the projects in which they
invest, and the banks to which or from which they obtain loans. Thus, the links
(network) created between banks is endogenous. Each bank is characterized by
parameters which define the return on its projects, the withdrawal rate of its depositors
and its equity available for investments. Maturity mismatch of balance sheets
forces a fraction of assets to be prematurely liquidated, at a fire sale cost. The paper
focuses on the impact of government intervention, which alleviates this cost by
increasing the recovery rate of assets. The fragility of a network is measured by the
number of bank failures following shocks of two kinds: first a shock to a single bank,
second a simultaneous shock to all banks. The first leads to a ranking of the banks
similar to that used by Google to rank websites: the higher its ranking the greater
the degree of vulnerability induced by the bank. The vulnerability of the network to
simultaneous shocks depends on the probability distribution of the banks characteristics:
the more dispersed the distribution the greater its vulnerability. Government
intervention increases the vulnerability of the network, the increase being greater
the more dispersed the characteristics of the banks. Banking systems with similar
leverage can have different degrees of vulnerability, highlighting the importance of
networks.