Efficiency and Stability of a Financial Architecture with Too-Interconnected-to-Fail Institutions

Abstract

The regulation of large interconnected financial institutions has become a key policy issue. To improve financial stability, regulators have proposed to limit banks' size and interconnectedness. I estimate a network-based model of the over-the-counter interbank lending market in 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, financial architecture, trading networks, trading efficiency, contagion risk, Federal funds market, simulated method of moments

JEL Classification: G18, G21, G28, D40, L14