Contagion in the interbank market: Funding versus regulatory constraints

• Across a wide range of possible network structures, contagion risk increases with the degree of maturity transformation and decreases with the size of the liquidity buffer of banks in the network.
• Whether one of the two contagion channels dominates depends on the capital buffer, the liquidity buffer and the level of interbank short-term debt.
• The relationship between interconnectedness and system stability depends on the size of the initial shock to asset values.
• The two contagion channels have different thresholds for the size of the initial shock beyond which more interconnections amplify contagion.
• Activating both contagion channels without letting them interact in the presence of unsecured debt leads to a mutual reinforcement of the two channels.
• Allowing the two contagion channels to interact through the relevance of accounting information for the roll-over decision on unsecured debt can mitigate or amplify systemic risk depending on which channel is dominating.

The contagion potential of mark-to-market accounting rules interacting with regulatory constraints is compared to that of funding constraints in a network of banks. The fair value accounting rules were amended at the height of the crisis to break the vicious link between allegedly irrational market prices and regulatory constraints. Anecdotal evidence from the recent crisis suggests that funding constraints posed more serious problems to banks than regulatory constraints. Simulation results show that, for low equity and high levels of short-term debt relative to liquid asset holdings, the contagion potential arising due to funding constraints is higher than the one due to accounting induced regulatory constraints. Allowing balance sheet valuation to affect the expectations about future insolvency, and implicitly, the roll-over decision of short-term creditors, can mitigate or amplify systemic risk depending on which contagion channel is dominating. These results could be interesting for a regulator wishing to achieve a trade-off between transparency, the main goal of fair value accounting, and financial stability.