Liquidity Networks in Banking

Modern financial and banking systems are very much interconnected. In a setting where banks are prone to liquidity risk due to early withdrawals by depositors, this paper analyzes the optimal liquidity network relationship that banks will settle. The paper interprets the network relationship as the exchange of 'committed credit lines' contracts between the banks. The paper shows that the given liquidity network of Allen and Gale (2000) is one of the optimal solutions that may occur and a risk-based pricing takes place in the interbank market. Banks dispose of their liquidity risk and reduce the total required cash holdings of the banking system to cover early withdrawals by means of this relationship. Additionally, the paper considers the case where liquidity shocks of banks become imperfectly negatively correlated. The network relationship between banks under imperfectly negatively correlated shocks is even robust to the extreme case, in which there is no reduction in the total required cash holdings of banks.