Efficiency and Stability of a Financial Architecture with Too-Interconnected-to-Fail Institutions

80 Pages Posted: 30 Dec 2012 Last revised: 17 Aug 2016

Date Written: March 23, 2016

Abstract

The regulation of large interconnected financial institutions has become a key policy issue. To improve financial stability, regulators have proposed to limit banks' size and interconnectedness. I estimate a network-based model of the over-the-counter interbank lending market in US and quantify the efficiency-stability implications of this policy. Trading efficiency decreases with limits on interconnectedness because the intermediation chains become longer. While restricting the interconnectedness of banks improves stability, the effect is non-monotonic. Stability also improves with higher liquidity requirements, when banks have access to liquidity during the crisis, and when failed banks' depositors maintain confidence in the banking system.

Keywords: financial regulation, financial architecture, trading networks, trading efficiency, contagion risk, Federal funds market, simulated method of moments

JEL Classification: G18, G21, G28, D40, L14

Suggested Citation

Gofman, Michael, Efficiency and Stability of a Financial Architecture with Too-Interconnected-to-Fail Institutions (March 23, 2016). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2194357 or http://dx.doi.org/10.2139/ssrn.2194357

Michael Gofman (Contact Author)

Simon School of Business ( email )

Rochester, NY 14627
United States

HOME PAGE: http://gofman.info

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