Abstract

Joint with A. David

We study optimal interconnections between banks in alternative banking systems created using interbank loans and over-the-counter derivatives. Settlements on all interbank payments are renegotiated in the event of financial distress of a counterparty. A high degree of interconnectectness plays a positive role as it commits counterparties to renegotiate claims to reduce dead weight liquidation costs in the system. We show that the renegotiable interbank loans form the optimal interconnection to the joint risk management and asset quality problem faced by the banks. In addition, our analysis shows that systemic spillovers and the likelihood of financial crises are severely mismeasured when interbank renegotiations are not considered. The optimality of interbank loans is shown to hold in a wide range of institutional settings.