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To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jebo.2004.07.018 Byline: Giulia Iori (a), Saqib Jafarey (a), Francisco G. Padilla (b) Keywords: Systemic risk; Contagion; Interbank lending Abstract: We simulate interbank lending. Each bank faces fluctuations in liquid assets and stochastic investment opportunities that mature with delay, creating the risk of liquidity shortages. An interbank market lets participants pool this risk but also creates the potential for one bank's crisis to propagate through the system. We study banking systems with homogeneous banks, as well as systems in which banks are heterogeneous. With homogeneous banks, an interbank market unambiguously stabilizes the system. With heterogeneity, knock-on effects become possible, but the stabilizing role of interbank lending remains so that the interbank market can play an ambiguous role. Author Affiliation: (a) Department of Economics, City University, Northampton Square, London EC1V 0HB, UK (b) Department of Mathematics, Kings College, Strand, London WC2R 2LS, UK Article History: Received 3 September 2003; Accepted 21 July 2004

The systemic risk involved in interbank lending is studied based on banking systems with homogeneous and heterogeneous banks.