We investigate the role of a central bank (CB) in preventing and avoiding financial contagion. The CB, by imposing reserve requirements on the banking system, trades off the cost of reducing the resources available for long-term investment with the benefit of raising liquidity to face an adverse shock that could cause contagious crises. We argue that contagion is not due to the structure of the interbank deposit market, but to the impossibility to sign contracts contingent on unforeseen contingencies. As long as incomplete contracts are present, the CB may have a useful role in curbing contagion. Moreover, the CB allows the banking system to reach first-best allocation in all the states of the world when the notion of incentive-efficiency is considered. If the analysis is restricted to constrained-efficiency, the CB still avoids contagion without, however, reaching first-best consumption allocation. The model provides a rationale for reserve requirements without the presence of fiat money or asymmetric information.

This paper analyzes the impact of incentive pay for bank managers on financial stability. The study focuses on two banks owned by risk-neutral principals but operated by risk-averse managers who decide on leverage and the extent of diversification into the other bank's assets, both of which determine the systemic risk. To begin, we establish the optimal incentive pay contract assuming a planner seeks to maximize the total value of the banks. In equilibrium, we find that the contract excessively relies on relative performance evaluation, leading to an inefficiently high degree of diversification, leverage, and systemic risk. This outcome obtains even when the principal represents the interests of all stakeholders in an individual bank. We demonstrate that only regulation specifically targeting relative performance evaluation can restore efficiency, while existing regulations on managerial pay can inadvertently amplify systemic risk.

This paper studies banks’ incentives to engage in liquidity cross-insurance. In contrast to previous literature we view interbank insurance as the outcome of bilateral (and non-exclusive) contracting between pairs of banks and ask whether this outcome is socially efficient. Using a simple model of interbank insurance we find that this is indeed the case when insurance takes place through pure transfers. This is even though liquidity support among banks sometimes breaks down, as observed in the crisis of 2007–2008. However, when insurance is provided against some form of repayment (such as is the case, for example, with credit lines), banks have a tendency to insure each other less than the socially efficient amount. We show that efficiency can be restored by introducing seniority clauses for interbank claims or through subsidies that resemble government interbank lending guarantees.

This article characterizes the interbank deposit network as a flow network that is able to channel liquidity flows among banks. These flows are beneficial, allowing banks to cope with liquidity risk. First, we analyze the efficiency of three network structures: star-shaped, complete, and incomplete in transferring liquidity among banks. The star-shaped interbank network achieves the complete coverage of liquidity risk with the smallest amount of interbank deposits held by each bank. This result implies that the star-shaped network is most resilient to systemic risk. Second, we analyze the banks’ decentralized interbank deposit decisions for a given network structure. We show that all network structures can generate an inefficiently low amount of interbank deposits. However, the star-shaped network induces banks to hold an amount of interbank deposits that is the closest to the efficient level. These results provide a rationale for consistent empirical evidence on sparse and centralized interbank networks.

We study the propagation of financial crises among regions in which banks are protected by limited liability and may take excessive risk. The regions are affected by negatively correlated liquidity shocks, so liquidity coinsurance is Pareto improving. The moral hazard problem can be solved if banks are sufficiently capitalized. Under autarky a limited amount of capital is sufficient to prevent risk‐taking, but when financial markets are open capital becomes insufficient. Thus, bankruptcy occurs with positive probability and the crisis spreads to other regions via financial linkages. Opening financial markets is nevertheless Pareto improving; consumers benefit from liquidity coinsurance, although they pay the cost of excessive risk‐taking.