Bilateral Netting and Contagion Dynamics in Financial Networks

Abstract

The bilateral netting of mutual obligations is an institutional arrangement employed in payment systems to reduce settlement risks. In this paper we explore its advantages and pitfalls when applied to an interbank lending market, in which banks extend credit to – and borrow from – other banks. Bilateral netting considerably reduce the potential for default cascades over an interbank network whenever the source of contagion is a negative shock to the assets of a randomly chosen bank. When the shock hits the liability side of the balance sheet, the mitigating effect of a bilateral netting agreement depends critically on the topological characteristics of the interbank network, however.