Abstract
The bilateral netting of mutual obligations is an institutional arrangement usually employed in payment systems to reduce settlement risks. In this paper we explore its advantages and pitfalls when applied to an inter-bank lending market, in which banks extend credit to - and borrow from - other banks to adjust their short-term liquidity needs. By recurring to computer simulations, we show that 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 - as a run on deposits - the role of a bilateral netting agreement in mitigating the risk of a systemic liquidity crisis depends critically on the topological characteristics of the interbank network, however.
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