Bilateral netting and systemic liquidity shortages in banking networks

The cross holding of interbank deposits represents an optimal ex-ante coinsurance arrangement whenever the uncertainty concerning banks’ liquidity needs is idiosyncratic and imperfectly correlated. When a shock to aggregate liquidity demand occurs, however, such an arrangement could be detrimental – depending on the topological structure of interlinkages - as financial exposures become a means to spread risk. If the ex-post facto is an excess demand for liquidity, therefore, regulators could severe potential channels of contagion by forcing banks to net their mutual debt obligations. Starting from these premises we employ simulation techniques with simple interbank structures to obtain two results. First, a state-contingent mandatory policy to bilaterally net mutual interbank exposures comes with a trade-off between the benefits of thwarting the channels of contagion and the harms of a greater concentration of the remaining netted expositions. Second, the balance between the two prongs of the trade-off depends on the metric used by regulators to define financial stability and the topological structure characterizing the interbank market.