Complexity, concentration and contagion

This paper develops a network model of interbank lending in which unsecured claims, repo activity and shocks to the haircuts applied to collateral assume centre stage. We show how systemic liquidity crises of the kind associated with the interbank market collapse of 2007-2008 can arise within such a framework, with funding contagion spreading widely through the web of interlinkages. Our model illustrates how greater complexity and concentration in the financial network may amplify this fragility. The analysis suggests how a range of policy measures - including tougher liquidity regulation, macro-prudential policy, and surcharges for systemically important financial institutions could make the financial system more resilient. (C) 2011 Bank of England. Published by Elsevier B.V. All rights reserved.