Are Over-the-Counter Derivatives Required for Interbank

In the absence of taxes, imperfect information, and importantly, additional regulation, the an-swer is “No”. Banks face the classic tradeoff between risk sharing and the incentive to maintain their asset quality. We show that under most economic circumstances, banks ’ value will be higher if they hedge with interbank loan contracts as long as the loan repayments can be renegotiated ex-post. Banks optimally create a highly interconnected network with large interbank debt that essentially commits ex-post solvent banks to bailing out all insolvent banks whenever the banking system as a whole is solvent. Standard bank regulation, however, sets constraints on the lending of a bank to any other bank and in the presence of constraints, derivatives usage becomes optimal as banks attempt to create the highly connected network. Our derivatives irrelevance result holds for a large range of liquidation costs, banks ’ costs to improve asset quality, weak and strong bankruptcy regimes, small and large banking systems, the presence of unhedgeable background risk, and re-serve requirements. Key Words: Systemic risk; interbank loans; renegotiation; bankruptcy mechanism; optimal risk-sharing network; derivatives irrelevanc