The global banking system: fragility, systemic risk and contagion

The turmoil in financial markets since the collapse of Lehman Brothers has provided a wake-up call for research on understanding the workings of the global banking system. What are the key factors causing fragility of the global banking system, severely impairing its crisis times ability to provide financial intermediation? What are the channels as to how adverse changes in the economic environment may drive up systemic risk and trigger financial crises? What scope does financial regulation have to limit systemic risk in the global banking system,and to reduce the probability and intensity of banking crises? To address this line of questions, it appears essential to move beyond a representative bank setting. Research in this work package will thus analyse complex networks of heterogeneous banks, subject also to major structural changes, such as the (relative) surge in banking globalization, banking deregulation and banking consolidation that took place in the years prior to the collapse of Lehman Brothers. Within such settings, it will then be examined how in the presence of moral hazard and asymmetric information adverse shocks may generate sudden interbank market freezes, bank runs and credit crunches. The network models of banking will also prove a fertile ground for the analysis of macro-prudential and monetary policy questions: Can it be avoided that individual banks become “too interconnected to fail”? Should central banks in the conduct of monetary policy account for dense liquidity linkages among banks.

Key Objectives

(O.3.1) Provide measures of systemic risk in the global banking system based on network models of banking and identify the driving forces for the variation of the systemic risk across normal and crisis regimes.

(O.3.2) Understand how changes in the financial and macroeconomic environment, including globalization, affect the scope for contagion in the banking system and its overall fragility.

(O.3.3) Understand the transmission of adverse shocks through the banking system, how they cause shifts between normal and crisis times, and how they spill over into the real economy.

(O.3.4) Examine how financial regulation may be employed to reduce systemic risk, the fragility of the banking system and thus also the amplitude of real contractions set off by banking crises.

Main participants