Why bigger bank networks may not be better？
KeAi Communications Co., Ltd.
image:
An illustration of a bank's balance sheet in the reserve x (a), survive (b) and bankrupt (c) when facing liquidity withdraws ω.
view moreCredit: Yu, T., He, X.-Z. (Tony), & Zhang, N.
Interbank lending can help banks manage unexpected withdrawals by allowing connected institutions to share liquidity. However, such connections can also create vulnerabilities: if one bank relies too heavily on its partners' reserves, stress may spread through the network.
In a new study published in Risk Sciences, researchers developed a model to examine why banks choose to form interbank credit networks and what network size may best support market efficiency.
The model considers two linked decisions. First, each bank chooses how much money to hold in reserve, balancing the profitability of lending against the need to survive liquidity shocks. Second, banks decide whether joining an interbank network would leave them better off than operating alone.
The analysis showed that banks may cooperate to share liquidity risk while simultaneously competing to reduce their own reserves and rely on others. The researchers described this strategic behaviour as a free-riding effect. While risk-sharing can make connections attractive, free-riding can lower reserves, weaken survival prospects, and reduce expected profits.
For smaller networks, the benefits of risk-sharing dominate. As more banks join, however, free-riding becomes increasingly important. This produces a rise-and-fall relationship between expected profits and network size, indicating that relatively small interbank networks can be Pareto optimal—meaning no participating bank can be made better off without making another worse off.
The study also examines networks involving banks of different sizes. It suggests that, under some conditions, smaller and larger banks can have incentives to connect even when their deposit sizes differ substantially. These findings provide a theoretical perspective on core-periphery banking structures, in which a small number of highly connected institutions interact with many smaller banks.
The authors note that implicit government guarantees may encourage banks to take greater risks and become excessively interconnected. Their results suggest that appropriately designed capital requirements could help limit the effects of free-riding and support market efficiency in larger networks.
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Contact the author:
Xue-Zhong (Tony) He
International Business School Suzhou, Xi' an Jiaotong-Liverpool University Suzhou, China
xuezhong.he@xjtlu.edu.cn
The publisher KeAi was established by Elsevier and China Science Publishing & Media Ltd to unfold quality research globally. In 2013, our focus shifted to open access publishing. We now proudly publish more than 200 world-class, open access, English language journals, spanning all scientific disciplines. Many of these are titles we publish in partnership with prestigious societies and academic institutions, such as the National Natural Science Foundation of China (NSFC).
Journal
Risk Sciences
Method of Research
Computational simulation/modeling
Subject of Research
Not applicable
Article Title
Interbank network and market efficiency
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