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Financial Networks: Contagion, Commitment, and Private Sector Bailouts

Authors

  • YARON LEITNER

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    • Leitner is at the Federal Reserve Bank of Philadelphia. This paper is a revision of the second chapter of my Ph.D. dissertation in finance at Northwestern University. An earlier draft is titled “Fragile Financial Networks.” I thank Mitchell Berlin, Philip Bond, Satyajit Chatterjee, Douglas Gale, Rick Green (the editor), Arvind Krishnamurthy, Leonard Nakamura, Adriano Rampini, an anonymous referee, and especially my main advisor, Michael Fishman, for helpful comments. I also thank seminar participants at the Federal Reserve Bank of Philadelphia, Northwestern University, Wharton (macro-lunch), the University of Haifa, Tel-Aviv University, Bar-Ilan University, the Hebrew University, and numerous conferences. The views expressed here are those of the author and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System.

ABSTRACT

I develop a model of financial networks in which linkages not only spread contagion, but also induce private sector bailouts, where liquid banks bail out illiquid banks because of the threat of contagion. Introducing this bailout possibility, I show that linkages may be optimal ex ante because they allow banks to obtain some mutual insurance even though formal commitments are impossible. However, in some cases (e.g., when liquidity is concentrated among a small group of banks), the whole network may collapse. I also characterize the optimal network size and apply the results to joint liability arrangements and payment systems.

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