Risk sharing framework and systemic tolerance in Indian banks: Double layer network approach

Abstract

Interconnectedness spreads systemic risk and is critical in enhancing banks’ systemic tolerance through interbank liquidity and lines of credit. Literature on systemic risk has not considered the importance of interconnectedness in providing liquidity to improve banks’ systemic tolerance. As a bank’s resistivity towards systemic disruption depends on its tolerance, the current article develops a model to measure the systemic tolerance of individual banks in a two-layer interbank network using ΔCoVaR. It estimates systemic tolerance distance through a risk-sharing framework and analyzes the significance of macroeconomic and bank-specific factors in explaining systemic tolerance. The results support that systemic tolerance values are higher during the down-cycle than the up-cycle, signaling the importance of interconnectedness in protecting against systemic crises. The empirics further substantiate that risk-sharing distance is lower, and structure is complex with clusters during economic down-cycle. This highlights that banks couple with each other during stressful environments and empirically validate the importance of interbank and lines of credit in enhancing systemic tolerance and, therefore, possess the regulator to develop a robust interbank market through regulatory guidelines.