Tongkui Yu (School of Computer and Information Science, Southwest University) Tony He (School of Economic and Finance, University of Technology, Sydney)
Banks usually borrow from each other when facing liquidity shortage. And the interbank lending network is considered to be crucial to financial stability. We provide a model of the endogenous formation of interbank credit alliance (a fully connected network) from the fundamental incentive of individual banks to maximize their expected profit. Banks will make two decisions in different time horizons. On a longer time scale, banks choose whether or not to build a mutual credit commitment with another bank; on a shorter time scale, they decide how much reserve to keep. It is unveiled that the interbank linkage has two effects. The first is the risk sharing effect which means that banks can share the reserves to cope with the stochastic liquidity demand, and this leads to a lower reserve and higher profit for the connected banks. The second is the free riding effect, which means that individual banks may lower their reserve further for even higher individual profit because the reserve is a public good shared by all connected banks but the profit from the unilaterally reduced reserve is enjoyed by the focal bank, and this effect leads to a Nash equilibrium with even lower reserves for all banks, this means higher probability of bankrupt and lower expected profit. When the size of coalition is small, the risk sharing effect dominates and increasing of the banks number can increase the profit of each bank. However, if the coalition size is large enough, the free riding effect dominates, and more banks joining in may lead to the decrease of each bank's profit.