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

January 2016
Michael Gofman

The regulation of large interconnected financial institutions has become a key policy issue. Regulators have proposed to limit size and interconnectedness of banks in order to improve financial stability. I estimate a network-based model of an OTC market and quantify the efficiency-stability tradeoff of such a policy. Trading efficiency decreases with limits on interconnectedness because intermediation chains become longer. Restricting interconnectedness of banks improves stability, but the effect is non-monotonic. Stability also improves with higher liquidity requirements, when banks have access to liquidity during the crisis, and when depositors of failed banks maintain confidence in the banking system.