Interbank Runs: A Network Model of Systemic Liquidity Crunches

Abstract

I study how interbank lending network structures affect financial fragility. Interbank lending is beneficial but subject to coordination failure. With interbank wholesale funding, banks' balance sheets become inflated, and give the senior retail depositors a sense of safety to allow more illiquid assets. In interbank runs, banks run on banks as they mutually reinforce each other to withdraw interbank lending. Banks' individually precautionary liquidity hoarding strategies are connected by the pairwise lending relationships. Mean-field analysis extracts the systemic behavior from the network of strategic interactions. I show such dispersed and indirectly linked interactions also lead to discontinuous and system-wide liquidity crunches, as if the interactions are centralized. Local insolvency shocks trigger the interbank run if the network is unraveled beyond a critical point. The model is applied to identify the optimal capital injection targets of government bailouts, and study the systemic effects of the proposed regulations on restraining the highly connected banks.