Abstract
AbstractWe study the efficiency properties of the formation of an interbank network. Banks face a trade‐off by establishing connections in the interbank market. On the one hand, banks improve the diversification of their liquidity risk and therefore can obtain a higher expected payoff. On the other hand, banks not sufficiently capitalized have risk‐shifting incentives that expose them to the risk of bankruptcy. Connecting to such risky banks negatively affects expected payoff. We show that both the optimal and the decentralized networks are characterized by a core‐periphery structure. The core is made of the safe banks, whereas the periphery is populated by the risky banks. Nevertheless, the two network structures coincide only if counterparty risk is sufficiently low. Otherwise, the decentralized network is underconnected as compared to the optimal one. Finally, we analyze mechanisms that can avoid the formation of inefficient interbank networks.
Highlights
It is theoretically established that banks have incentives to form bilateral lending relationships
We show that the structure of the decentralized interbank network is the same as the constrained first-best (CFB) one if the counterparty risk is su ciently low
The intuition is that when counterparty risk is small with respect to the benefits provided by the interbank network, connecting until the last gambling bank in the network increases the total expected payo↵
Summary
It is theoretically established that banks have incentives to form bilateral lending relationships. The present model captures the features of the banking models (such as the benefits stemming from liquidity coinsurance as in Allen and Gale [6], and the gambling behavior of low capitalized banks as in Brusco and Castiglionesi [14] or Morrison and White [34]), but it directly addresses the issues of the optimal design of the network and its decentralized formation. Farboodi [24] provides a rationale for the existence of a core-periphery banking network Her model predicts that the core banks are those who invest in risky projects that allow them to o↵er high expected returns. We instead consider explicitly moral hazard problems in which banks have heterogenous returns (i.e., banks that invest in the gambling project have lower expected return) This turns out to be the main reason for the core-periphery structure to emerge both as the optimal and decentralized network.
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