Interbank credit exposures and financial stability

Oren Schneorson

No 136, ESRB Working Paper Series from European Systemic Risk Board

Abstract: This paper investigates how interbank credit exposures affect financial stability. Policy makers often see such exposures as undermining stability by exacerbating cascading losses through the financial system. I develop a model that features a trade-off between cascading losses and risk-sharing. In contrast to previous studies I find that reducing interbank connectivity may destabilize the financial system via the bank-run channel. This is because it decreases the risk-sharing benefits of interbank connectivity. A bank-run model features two islands that are connected via a long term debt claim. Varying the size of this claim (interbank connectivity), I study how the decision to `run on the bank' is affected. I run a simulation of the model, calibrated to the U.S. banking system between 1997-2007. I find that large bankruptcy costs are required to trump the risk-sharing benefits of interbank credit exposures. JEL Classification: G01, G21, G28

Keywords: bank runs; credit risk; derivatives; financial stability (search for similar items in EconPapers)
Date: 2022-08
New Economics Papers: this item is included in nep-ban, nep-cba, nep-fdg, nep-mon and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:srk:srkwps:2022136

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