(In)Efficient interbank networks

Fabio Castiglionesi, Noemi Navarro

Research output: Contribution to journalArticleScientificpeer-review

Abstract

We study the efficiency properties of the formation of an interbank network. Banks face a trade‐off by establishing connections in the interbank market. On the one hand, banks improve the diversification of their liquidity risk and therefore can obtain a higher expected payoff. On the other hand, banks not sufficiently capitalized have risk‐shifting incentives that expose them to the risk of bankruptcy. Connecting to such risky banks negatively affects expected payoff. We show that both the optimal and the decentralized networks are characterized by a core‐periphery structure. The core is made of the safe banks, whereas the periphery is populated by the risky banks. Nevertheless, the two network structures coincide only if counterparty risk is sufficiently low. Otherwise, the decentralized network is underconnected as compared to the optimal one. Finally, we analyze mechanisms that can avoid the formation of inefficient interbank networks.
Original languageEnglish
Pages (from-to)365-407
JournalJournal of Money, Credit and Banking
Volume52
Issue number2-3
DOIs
Publication statusPublished - 1 Mar 2020

Keywords

  • interbank network
  • core-periphery
  • liquidity coinsurance
  • counterparty risk

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