Contagion and risk-sharing on the interbank market

Increasing numbers of inter-bank lending relationships have an ambiguous effect on financial stability. Studies have shown that fewer inter-bank loans limit the spread of bankruptcies whilst other work has argued that greater connectivity aids risk sharing. In this paper we identify the conditions under which each relationship holds. Using numerical techniques we demonstrate that in response to a large economy-wide shock, higher numbers of inter-bank lending relationships worsen the impact of the event, however, for smaller shocks the opposite relationship is observed. As such there is no optimal inter-bank market structure which reduces contagion under all economic conditions.