The formation of a core-periphery structure in heterogeneous financial networks

Recent empirical evidence suggests that financial networks exhibit a core-periphery net- work structure.  This paper aims at giving an explanation for the emergence of such a structure using network formation theory. We  propose a simple model of the overnight interbank lending market, in which banks compete for intermediation benefits. Focusing on the role of bank heterogeneity, we find that a core-periphery network cannot be unilaterally stable when banks are homogeneous. A core-periphery network structure can form endogenously, however, if we allow for heterogeneity among banks in size. Moreover, size heterogeneity may arise endogenously if payoffs feed back into bank size.
 
Keywords: financial networks, core-periphery structure, network formation models, over-the-counter markets, interbank market.
JEL classifications: D85, G21, L14.

Working paper no. 528.