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

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  • Gofman, Michael

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.

Suggested Citation

  • Gofman, Michael, 2017. "Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions," Journal of Financial Economics, Elsevier, vol. 124(1), pages 113-146.
  • Handle: RePEc:eee:jfinec:v:124:y:2017:i:1:p:113-146
    DOI: 10.1016/j.jfineco.2016.12.009
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    Citations

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    Cited by:

    1. Heller, Yuval & Peleg Lazar, Sharon & Raviv, Alon, 2019. "Banks Risk Taking and Creditors Bargaining Power," MPRA Paper 91381, University Library of Munich, Germany.
    2. repec:uts:finphd:5-2018 is not listed on IDEAS
    3. Stefan Nagel & Amiyatosh Purnanandam, 2019. "Bank Risk Dynamics and Distance to Default," NBER Working Papers 25807, National Bureau of Economic Research, Inc.
    4. Abedifar, Pejman & Giudici, Paolo & Hashem, Shatha Qamhieh, 2017. "Heterogeneous market structure and systemic risk: Evidence from dual banking systems," Journal of Financial Stability, Elsevier, vol. 33(C), pages 96-119.
    5. Bryan S. Graham, 2019. "Network Data," Papers 1912.06346, arXiv.org.
    6. repec:eee:dyncon:v:103:y:2019:i:c:p:205-233 is not listed on IDEAS
    7. repec:eee:ememar:v:35:y:2018:i:c:p:1-18 is not listed on IDEAS
    8. Ozili, Peterson K, 2017. "Earnings Management in Interconnected Networks: A Perspective," MPRA Paper 92647, University Library of Munich, Germany.
    9. Zafer Kanık, 2017. "Rescuing the Financial System: Capabilities, Incentives, and Optimal Interbank Networks," Working Papers 17-17, NET Institute.
    10. repec:gam:jrisks:v:7:y:2019:i:2:p:46-:d:226193 is not listed on IDEAS
    11. Benigno, Pierpaolo & Robatto, Roberto, 2019. "Inefficiency and Regulation of Private Liquidity," CEPR Discussion Papers 13631, C.E.P.R. Discussion Papers.
    12. Navarro, Noemí & Tran, Dan H., 2018. "Shock Diffusion in Regular Networks: The Role of Transitive Cycles," MPRA Paper 86267, University Library of Munich, Germany.

    More about this item

    Keywords

    Financial regulation; Networks; Trading efficiency; Contagion risk; Federal funds market;

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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