Interbank network and bank bailouts: Insurance mechanism for non-insured creditors?I

In this paper we present a theory that explains why it is beneficial for banks to engage in circular lending activities on the interbank market. Using a simple network structure, we show that if there is a non-zero bailout probability, banks can significantly increase the expected repayment of uninsured creditors by entering into cyclical liabilities on the interbank market before investing in loan portfolios. Therefore, banks are better able to attract funds from uninsured creditors. Our results show that implicit gov-ernment guarantees incentivize banks to have large interbank exposures, to be highly interconnected, and to invest in highly correlated, risky portfolios. This can serve as an explanation for the observed high interconnectedness between banks and their investing behavior in the run-up to the subprime mortgage crisis