Interbank netting agreement and the distribution of bank default risk

Central banks and private banks alike have advocated greater use of interbank netting agreements in recent years in order to reduce potential for transmitting economic shocks through interbank markets. This paper provides a model of an interbank payment market and shows that one sideeffect of greater netting of interbank claims is a redistribution of bank default risk away from interbank claimants toward non-bank creditors of banks, including the deposit insurer. Interbank netting agreements thus involve a trade-off between reduced interbank credit-risk exposure and increased concentration of bank default risk on other sets of bank creditors.