A Network Theory of Safety Premium

Abstract

Interconnected banks are prone to the propagation of negative shocks. In a network with banks borrowing from each other using collateral, the risk of financial contagion leads to the emergence of multiple equilibria, featuring different sizes of loans and collateral haircuts. Safe assets are traded at a premium because safe collateral helps the economy to deter the propagation of negative shocks. A small decrease in collateral quality, increasing the contagion risk, might lead to an equilibrium jump to one with a smaller amount of interbank lending, along with which the safety premium will suddenly increase.