Interbank Networks Formed via Money Circulation, Too Connected to Fail and System Meltdown

Abstract

This paper considers the issue of "Too Connected to Fail" (TCTF) for a system of banks endogenously interconnected with both credit and insurance claims. The interbank credit network results from the circulation of banks' liabilities as a means of payment. By tracking their circulation, this paper considers the general equilibrium effect of bank lending for households' incomes and deposits. Thereby, we find that the network of banks interconnected with credit claims alone, while of a star structure, has no issue of TCTF. If the interbank insurance is introduced, the bank at the center becomes the sole provider of insurance to all the other banks. It then becomes systemically important. In some contingencies, it fails and that triggers bank run to almost all the other banks. There exists early warning for this event of system meltdown. Lastly, we show that the effect of the interbank interest rate for banks' lending depends on their positions in the network; and that the premium of the insurance is negatively related to the interbank interest rate and can be so low as to generate losses to the insurer.

Keywords: too connected to fail, interbank credit network, interbank insurance, systemically important institute, system meltdown, early warning

JEL Classification: G21, D85