Propagation of credit freezes in financial lending networks

Abstract

We consider a network model of financial intermediation where banks (financial intermediaries) lend to and borrow from each other and supply funds to clients. A key decision for a bank is whether to extend credit to other banks, which may then default on those loans. In contrast to much of the previous literature on financial networks, the focus is on how "fear of future default" can lead to "credit freezes" before the realization of these uncertainties. Specifically, we show that increases in the riskiness of one or few banks can lead to systemic credit freeze throughout the financial network. Notably, credit freezes can happen in parts of the network that are not directly affected by increased uncertainty, both because the potential consequences of uncertainty travel throughout the network and also because such changes affect profitability of loans between different parties. We then use this framework to analyze the effects of policy interventions on systemic credit freezes.