Bilateral netting and contagion dynamics in financial networks

Edoardo Gaffeo and Lucio Gobbi

No 2015/02, DEM Discussion Papers from Department of Economics and Management

Abstract: The bilateral netting of mutual obligations is an institutional arrange- ment usually employed in payment systems to reduce settlement risks. In this paper we explore its advantages and pitfalls when applied to an inter- bank lending market, in which banks extend credit to nÃÉand borrow from nÃÉother banks to adjust their short-term liquidity needs. By recurring to computer simulations, we show that bilateral netting considerably reduce the potential for default cascades over an interbank network whenever the source of contagion is a negative shock to the assets of a randomly chosen bank. When the shock hits the liability side of the balance sheet nÃÉas a run on deposits nÃÉthe role of a bilateral netting agreement in mitigating the risk of a systemic liquidity crisis depends critically on the topological characteristics of the interbank network, however.

Keywords: Bilateral netting; financial networks; contagion (search for similar items in EconPapers)
Date: 2015
New Economics Papers: this item is included in nep-ban, nep-cmp and nep-net
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