Financial Networks: Contagion, Commitment, and Private-Sector Bailouts

Introducing this bailout possibility, the author shows that linkages may be optimal ex-ante because they allow banks to obtain some mutual insurance even though formal commitments are impossible. However, in some cases (for example, when liquidity is concentrated among a small group of banks), the whole network may collapse. The author also characterizes the optimal network size and applies the results to joint liability arrangements and payment systems.