Criticality in a model of banking crises

An interbank market lets participants pool the risk arising from the combin ation of illiquid investments and random withdrawals by depositors. But it also creates the potential for one bank's failure to trigger off avalanches of further failures. We simulate a model of interbank lending to study the interplay of these two effects. We show that when banks are similar in siz e and exposure to risk, avalanche effects are small so that widening the in terbank market leads to more stability. But as heterogeneity increases, ava lanche effects become more important. By var,ring the heterogeneity and con nectivity across banks, the system enters a critical regime with a power la w distribution of avalanche sizes. (C) 2001 Elsevier Science B.V. All right s reserved.