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Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions

Michael Gofman

Journal of Financial Economics, 2017, vol. 124, issue 1, 113-146

Abstract: The regulation of large interconnected financial institutions has become a key policy issue. To improve financial stability, regulators have proposed limiting banks’ size and interconnectedness. I estimate a network-based model of the over-the-counter interbank lending market in the US and quantify the efficiency-stability implications of this policy. Trading efficiency decreases with limits on interconnectedness because the intermediation chains become longer. While restricting the interconnectedness of banks improves stability, the effect is non-monotonic. Stability also improves with higher liquidity requirements, when banks have access to liquidity during the crisis, and when failed banks’ depositors maintain confidence in the banking system.

Keywords: Financial regulation; Networks; Trading efficiency; Contagion risk; Federal funds market (search for similar items in EconPapers)
JEL-codes: G18 G21 G28 D40 L14 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:eee:jfinec:v:124:y:2017:i:1:p:113-146