The Concentration of the Banking Industry and Its Exposure to Financial Contagion

Abstract

This paper focuses on the effects that the concentration of the banking industry has on its exposure to the risk of systemic crises due to direct, balance-sheet financial contagion. Studying three stylized (and analytically tractable) classes of interbank networks – namely the complete, star and ring networks – we show that the magnitude of the smallest insolvency shock that is capable of causing the default of all banks in the system depends on the degree of concentration of the industry. Concerning complete and ring interbank networks, we obtain that the more concentrated the banking system is, the smaller the magnitude of the shock that induces the insolvency of the entire system. That is, concentration renders the banking system more fragile. Conversely, we show that the opposite applies to star interbank networks – i.e. networks composed of a bank at the centre connected to a set of peripheral banks that are not connected among themselves. In this case, the more concentrated the industry, the larger the smallest shock that causes a systemic crisis, i.e. the smaller the exposure to systemic risk.