Financial Contagion in the Laboratory: Does Network Structure Matter?

Date: 2016-06
By: John Duffy (Department of Economics, University of California-Irvine)
Aikaterini Karadimitropoulou (School of Economics, University of East Anglia)
Melanie Parravano (Business School, Newcastle University)
We design and report on laboratory experiments exploring the role of interbank network structure for the likelihood of a financial contagion. The laboratory provides us with the control necessary to precisely explore the role of different network configurations for the fragility of the financial system. Specifically, we study the likelihood of financial contagion in complete and incomplete networks of banks who are linked in terms of interbank deposits as in the model of Allen and Gale (2000). Subjects play the role of depositors who must decide whether or not to withdraw their funds from their bank. We find that financial contagions are possible under both network structures. While such contagions always occur under an incomplete interbank network structure, they are significantly less likely to occur under a complete interbank network structure where interbank linkages can effectively provide insurance against shocks to the system, and localize damage from the financial shock.
Keywords: Contagion; Networks; Experiments; Bank runs,; Interbank seposits; Financial fragility
JEL: C92 E44 G21