The Optimality of Interbank Liquidity Insurance

EFA 2009 Bergen Meetings Paper

26 Pages Posted: 28 Jul 2008 Last revised: 30 Jan 2010

See all articles by Fabio Castiglionesi

Fabio Castiglionesi

Tilburg University - Department of Finance

Wolf Wagner

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM); Centre for Economic Policy Research (CEPR)

Date Written: December 1, 2009

Abstract

This paper studies banks' incentives to engage in liquidity cross-insurance. In contrast to previous literature we view interbank insurance as the outcome of bilateral (and non-exclusive) contracting between pairs of banks and ask whether this outcome is socially efficient. Using a simple model of interbank insurance we find that this is indeed the case when insurance takes place through pure transfers. This is even though liquidity support among banks sometimes breaks down, as observed in the crisis of 2007-2008. However, when insurance is provided against some form of repayment (such as is the case, for example, with credit lines), banks have a tendency to insure each other less than the socially efficient amount. We show that efficiency can be restored by introducing seniority clauses for interbank claims or through subsidies that resemble government interbank lending guarantees. Interestingly, even considering generic externalities among banks we find that there cannot be situations where banks insure more than is efficient. Such insurance, however, may arise if banks receive regulatory subsidies (explicit or implicit) in case they fail jointly.

Keywords: Liquidity Coinsurance, Interbank Markets, Non-exclusive Contracts

JEL Classification: G21

Suggested Citation

Castiglionesi, Fabio and Wagner, Wolf, The Optimality of Interbank Liquidity Insurance (December 1, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1180122 or http://dx.doi.org/10.2139/ssrn.1180122

Fabio Castiglionesi

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Wolf Wagner (Contact Author)

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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