Efficiency and stability of financial systems
The lecture focuses on the interconnectedness of banks and financial intermediaries and the consequent trade-off between the efficiency and stability of financial systems. In a financial system, banks are connected directly, through networks of financial obligations, and indirectly because they often hold overlapping and correlated portfolios. Networks of interbank obligations arise in several contexts–such as payment systems, trading in risk-sharing assets (e.g. CDS, CDO, etc.), cross-holding of liquid positions meant to provide liquidity coinsurance, etc. On the one hand, these interbank claims stem from lucrative trading opportunities and risk-sharing activities, enhancing the system’s efficiency. On the other hand, they become channels of direct balance-sheet contagion in case of bankruptcy of one or more banks.Similarly, banks can share counterparty risk through syndicated loans, reducing the idiosyncratic risk of a single bank and, at the same time, increasing the risk of systemic crises due to common shocks. For these reasons, a trade-off exists between efficiency and stability: the more banks are interconnected, the more efficient the system is in reallocating risk. At the same time, the larger the value of interbank claims and common asset holdings, the more the system is exposed to the risk of financial contagion and systemic crises. In the lecture, I will review the main literature on financial contagion and present the most recent results on the above-described trade-off between the efficiency and stability of banking systems.