Gauging the Effectiveness of Cross-Sectional Macro-Prudential Tools through the Lens of Interbank Networks

This special feature examines various macro-prudential tools through the lens of recent advances in the study of interbank contagion. The specific set of tools analysed are those designed to contain the “cross-sectional” dimension of systemic risk – that is, those designed to limit the systemic risk stemming from factors such as correlations and common exposures across financial institutions. These include tools such as large exposure limits and other regulatory requirements designed to limit the spread of systemic risk between banks. The analysis rests on the basic notion that interbank network structures, and hence the risk of contagion across the banking system in response to shocks, are influenced by banks’ optimising behaviour subject to regulatory (and other) constraints. Changes in macro-prudential policy parameters, such as large exposure limits, capital charges on counterparty exposures and capital and liquidity requirements more generally, will affect the contagion risk because of their impact on banks’ asset allocation and interbank funding decisions. This in turn implies that well-tailored macro-prudential policy can help reduce interbank contagion risk by making network structures more resilient. The analysis shows that to capture the full extent of potential interbank contagion, all of the different layers of bank interaction should be taken into account. Hence, if the regulator only focuses on one segment of interbank relationships (e.g. direct bilateral exposures), the true contagion risks are likely to be grossly underestimated. This finding has clear policy implications and flags the importance of micro- and macro-prudential regulators having access to sufficiently detailed data so as to be able to map the many interactions between banks. JEL Classification: G00