Emergence of a core-periphery structure in a simple dynamic model of the interbank market

This paper studies a simple dynamic model of interbank credit relationships. Starting from a given balance sheet structure of a banking system with a realistic distribution of bank sizes, the necessity of establishing interbank credit connections emerges from idiosyncratic liquidity shocks. Banks initially choose potential trading partners randomly, but over time form preferential relationships via an elementary reinforcement learning algorithm. As it turns out, the dynamic evolution of this system displays a formation of a core-periphery structure with mainly the largest banks assuming the roles of money center banks mediating between the liquidity needs of many smaller banks. Statistical analysis shows that this evolving interbank market shares the majority of the salient characteristics of interbank credit relationship that have been put forth in recent literature. Preferential interest rates for borrowers with strong attachment to a lender may prevent the system from becoming extortionary and guarantee the survival of the small peripherical banks.The author is extremely grateful for the hospitality of the Financial Stability Assessment Division of the European Central Bank as well as very stimulating discussions with Christoffer Kok, Grzegorz Halaj, Mattia Montagna, Michael Wellman, Cars Hommes, Falk Bräuning, Herbert David and Shu-Heng Chen. Helpful comments from the audience of CEF 2014 in Oslo as well as from participants in various other seminars and workshop presentations are also gratefully acknowledged. I am also very thankful for the research assistance of Ricardo Giglio. This report is part of a research initiative founded by the Leibniz Community. The research leading to these results has also received funding from the Spanish Ministry of Science and Innovation (ECO2011-23634), from Universitat Jaume I (P1.1B2012-27) and from the European Union Seventh Framework Programme (FP7/2007-2013) under Grant agreement no. 612955