Real shocks and financial contagion

Our goal in this paper is to develop a model where real shocks can generate financial crisis, while financial shocks can also propagate to the real sector. We extend an influential model of the banking sector to include linkages to the corporate sector. Gai, Haldane, and Kapadia (2011) showed that interlinkages between banks can amplify localized shocks into systemic liquidity crises.  GHK also demonstrated that complexity and concentration in the interbank network can increase financial fragility. Our model generally supports these results but suggests an important role for the real sector.

The GHK banking sector exists in peculiar isolation, with no explicit links to a corporate sector nor to a central bank.  This paper addresses the first of these problems.  After replicating the GHK network model of the banking sector, we couple this banking model with a simple agent-based model of corporate sector. Our use of agent-based methods allow us to identify firm-level and bank-level heterogeneities that play a crucial role in the propagation of liquidity problems. (For example, an individual firms may fail to repay a bank loan, creating liquidity difficulties at an individual bank.)  We emphasize dynamic linkages between firms and banks. (For example, a bank will stop lending to a firm that falls into arrears.)  We show how our addition of a simple corporate sector sheds light on the sources of financial fragility, the mechanisms of propagation from the real sector to the financial sector, and the implications of financial fragility for the real sector. We conclude with some recommendations for prudential bank regulation.