Why are Banks Highly Interconnected?

Abstract:     
We study optimal interconnections between banks in alternative banking systems created using interbank loans and over-the-counter derivatives. Settlements on all interbank payments are renegotiated in the event of financial distress of a counterparty. Interconnections in our analysis play a positive role since they serve as a commitment device to facilitate mutual private sector bailouts to lower the need for government bailouts. We show that the renegotiable interbank loans form the optimal interconnection to the joint risk management and asset quality problem faced by banks. In addition, our analysis shows that systemic spillovers and the likelihood of financial crises are severely mismeasured when interbank renegotiations are not considered. The optimality of interbank loans is shown to hold in a wide range of institutional settings.

Number of Pages in PDF File: 58

Keywords: Systemic risk, interbank loans, multilateral renegotiation, bankruptcy mechanism, optimal risk-sharing network, financial crises

JEL Classification: G21, C1, C78, C81, E44

working papers series