Optimal Fragile Financial Networks

We study a financial network characterized by the presence of depositors, banks and their shareholders. Belonging to a financial network is beneficial for both the depositors and banks' shareholders since the return to investment increases with the number of banks connected. However, the network is fragile since banks, which invest on behalf of the depositors, can gamble with depositors' money (making an investment that is dominated in expected terms) when not sufficiently capitalized. The bankruptcy of a bank negatively affects the banks connected to it in the network. First, we compute the social planner solution and the efficient financial network is characterized by a core-periphery structure. Second, we analyze the decentralized solution showing under which conditions participating in a fragile financial network is ex-ante optimal. In particular, we show that this is optimal when the probability of bankruptcy is sufficiently low giving rationale of financial fragility as a rare phenomenon. Finally, we analyze the efficiency of the decentralized financial network. Again, if the probability of bankruptcy is sufficiently low the structure of the decentralized financial network is equal to the e¢ cient one, yielding an ex- pected payo¤ arbitrarily close to the efficient one. However, the investment decision is not the same. That is, in the decentralized network some banks will gamble as compared to the socially preferred outcome.Financial Network;Moral Hazard;Financial Fragility

Optimal Fragile Financial Networks

We study a financial network characterized by the presence of depositors, banks and their shareholders. Belonging to a financial network is beneficial for both the depositors and banks' shareholders since the return to investment increases with the number of banks connected. However, the network is fragile since banks, which invest on behalf of the depositors, can gamble with depositors' money (making an investment that is dominated in expected terms) when not sufficiently capitalized. The bankruptcy of a bank negatively affects the banks connected to it in the network. First, we compute the social planner solution and the efficient financial network is characterized by a core-periphery structure. Second, we analyze the decentralized solution showing under which conditions participating in a fragile financial network is ex-ante optimal. In particular, we show that this is optimal when the probability of bankruptcy is sufficiently low giving rationale of financial fragility as a rare phenomenon. Finally, we analyze the efficiency of the decentralized financial network. Again, if the probability of bankruptcy is sufficiently low the structure of the decentralized financial network is equal to the e¢ cient one, yielding an ex- pected payo¤ arbitrarily close to the efficient one. However, the investment decision is not the same. That is, in the decentralized network some banks will gamble as compared to the socially preferred outcome.

Interbank borrowing and lending between financially constrained banks

Some stylized facts about transactions among banks are not easily reconciled with coinsurance of short-term liquidity risks. In our model, interbank markets play a different role. We argue that lending to another bank can reduce a bank’s overall portfolio risk through diversification. If insolvency is costly, this diversification improves the interbank lender's funding liquidity, boosting credit supply to nonbanks. However, diversification comes at an endogenous cost that depends on bank-specific factors of interbank borrower and lender. The model provides a framework for understanding the importance of interbank lending for aggregate credit supply and the stability of banking systems. The model’s predictions are consistent with evidence documented in the literature that other theories cannot consistently explain

Optimal Fragile Financial Networks

We study a financial network characterized by the presence of depositors, banks and their shareholders. Belonging to a financial network is beneficial for both the depositors and banks' shareholders since the return to investment increases with the number of banks connected. However, the network is fragile since banks, which invest on behalf of the depositors, can gamble with depositors' money (making an investment that is dominated in expected terms) when not sufficiently capitalized. The bankruptcy of a bank negatively affects the banks connected to it in the network. First, we compute the social planner solution and the efficient financial network is characterized by a core-periphery structure. Second, we analyze the decentralized solution showing under which conditions participating in a fragile financial network is ex-ante optimal. In particular, we show that this is optimal when the probability of bankruptcy is sufficiently low giving rationale of financial fragility as a rare phenomenon. Finally, we analyze the efficiency of the decentralized financial network. Again, if the probability of bankruptcy is sufficiently low the structure of the decentralized financial network is equal to the e¢ cient one, yielding an ex- pected payo¤ arbitrarily close to the efficient one. However, the investment decision is not the same. That is, in the decentralized network some banks will gamble as compared to the socially preferred outcome

On the efficiency of bilateral interbank insurance

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