The Link Between Incomplete Information on the Interbank Network and Counterparty Risk

This paper describes a model in which a network of interbank loans leads to a severe amplification of the previously unanticipated insolvency of one bank. Banks that cannot rule out an indirect hit react by selling assets and hoarding liquidity. While this potentially lowers illiquidity risks, it depresses market liquidity and prices. This leads to a negative externality by which sales to acquire liquidity simultaneously lead to lower global sale proceeds and thus to a greater number of insolvencies inducing deadweight losses. Thus, the distribution of information on the network has a direct impact on welfare by itself.