The economics of netting in financial networks

Abstract

Can the netting of on-balance-sheet interbank assets and liabilities be useful in thwarting financial contagion during a systemic crisis episode? In order to answer this question, in this paper we use mean-field approximation techniques and computer simulations to comparatively assess how contagion spreads out throughout an interbank network under different settlement modes. We find that a regulator forcing banks to net their credit/debt obligations instead of allowing them to regulate their mutual exposures on a gross basis succeeds in reducing the number of defaults and in preserving the aggregate amount of bank capital. Interbank netting takes its toll on retail depositors by increasing their potential losses, however. Hence, our analysis provides support for an optimal crisis-management policy mix that combines the enforcement of bilateral netting with a blanket deposit insurance scheme. The desirability of netting increases when the system is highly connected and susceptible to large shocks, especially when strains are first detected in banks located at the core of the network.