Rescuing the Financial System: Capabilities, Incentives, and Optimal Interbank Networks

I model bank rescues in a setting where banks hold each other’s financial instruments, creating a network of financial linkages. Costly bankruptcies reduce interbank payments, which creates incentives for rescues by other banks. I show that the government’s bail-out costs are minimized if regulators promote financial networks that are evenly connected and have intermediate levels of interbank liabilities but interestingly have low diversification at the bank level. Such networks maximize banks’ contributions to the rescue of a distressed bank hit by a relatively small negative shock, but also ensure that banks do not fail sequentially like dominos when a bank hit by a large shock does actually fail. The results also provide a rationale for why some systemically important banks such as Lehman Brothers or Washington Mutual were not rescued in 2007-2008. In the model, a welfare-maximizing government assists the rescues designed to prevent domino failures and maintain financial stability instead of assisting the rescue of a bank that is hit by a large shock.