The Optimality of Interbank Liquidity Insurance
EFA 2009 Bergen Meetings Paper
26 Pages Posted: 28 Jul 2008 Last revised: 30 Jan 2010
Date Written: December 1, 2009
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: Suggested Citation