The financial crisis of 2007-2009 showed how interconnectedness among financial institutions can pose systemic risk to the financial system. When a highly interconnected institution becomes distressed, as happened with Lehman Brothers, its counterparties may also experience losses and limited access to liquidity. An idiosyncratic shock to one institution can turn into a systemwide shock. In response, economists and policymakers have attempted to assess the relationship between network structure and systemic risk.
While many theoretical models have been introduced, existing empirical work has been limited by several important challenges. One notable challenge originates from the lack of detailed comprehensive data on the structure of financial networks. First, with limited information on the topology of financial networks, it is difficult to assess systemic susceptibility to contagion. Second, it is challenging to disentangle counterparty exposures arising from various instruments.
Our paper takes a historical approach, by examining how the National Banking Acts (NBAs) of 1863-1864 in the US changed the structure of bank networks and affected the stability of the banking system. The NBAs allowed banks to meet legal requirements by maintaining a large portion of interbank deposits in designated cities. The resulting reserve hierarchy consolidated New York City's position as the nation's money center. Using unique data on bank balance sheets along with detailed interbank deposits in 1862 and 1867 in Pennsylvania, we analyze how the NBAs reshaped the topology of interbank networks and banks' liquidity management. Then we build a model and quantitatively examine how the changes in interbank networks affect the transmission of liquidity shocks in the banking system.
Data show that the reserve pyramid with three distinct tiers emerged as new reserve requirements were enforced after the NBAs. This pattern arises because interbank deposits became heavily concentrated in cities designated as reserve and central reserve cities. First, New York City became the ultimate destination of interbank deposits. The size of correspondent deposits in New York City grew much larger than those in Philadelphia. Second, Pittsburgh emerged as a new financial center after it was designated as a reserve city. At the same time, other regional centers experienced a reduction in the interbank deposits held by rural banks. Third, banks in financial centers increased their cash holdings in order to create larger liquidity buffers in the event of deposit withdrawals.
To examine how the concentration of interbank deposits at reserve and central reserve cities affects the stability of the banking system and the extent of contagion, we build a network model of interbank deposits. The model embeds liquidity withdrawals in the interbank payment system introduced by Eisenberg and Noe (2001). In this two-period model, banks may experience runs and asset liquidation due to a maturity mismatch between short-term liquid liabilities and long-term illiquid asset investments. Such a framework allows us to study the impact of banking panics due to deposit withdrawals, by both local and institutional depositors. Using this model, we simulate two types of banking crises: triggered by investment losses of New York City banks and liquidity shortages at banks outside financial centers, respectively. Then we compare the systemic risk measures for the years before and after the NBAs.
Our results show that, as the interbank deposits became more concentrated, the NBA induced a ‘robust-yet-fragile’ nature to the system's resiliency, which echoes the ‘knife-edge flipping’ concept in Haldane (2013). The banking system becomes more robust as long as the most connected institutions do not face large liquidity shocks. However, when expected losses are large enough to trigger massive withdrawals and liquidation at the most connected New York City banks, links start to serve as channels for contagion. Financial center banks fail to repay deposits in full to their respondents, thereby causing runs and systemic liquidation. We also find that the concentrated interbank network after the NBAs is more resilient to liquidity shocks originating from banks outside financial centers. Even though the interbank linkages pass on contagious withdrawals upwards along the pyramid, financial center banks are liquid enough to meet such demand.
This study provides new insights into financial regulations related to the architecture of the financial system. One of the key proposals for regulatory reform following the financial crisis of 2007-2009 is the mandatory clearing of standardized over-the-counter (OTC) derivatives through central counterparties (CCPs). This regulatory change has radically reshaped the interconnected structure among counterparties and in turn has cast CCPs as systemically important financial institutions. While this regulatory reform is intended to mitigate counterparty risk and contagion, its equilibrium effect on financial resilience remains unclear. Our study contributes by analyzing a regulatory change to a historical banking system that is structurally similar to the effect of mandatory central clearing.
Jessie Jiaxu Wang is an Assistant Professor of Finance at the Arizona State University, W. P. Carey School of Business.