Bilateral netting and contagion dynamics in financial networks

The bilateral netting of mutual obligations is an institutional arrange- ment usually employed in payment systems to reduce settlement risks. In this paper we explore its advantages and pitfalls when applied to an inter- bank lending market, in which banks extend credit to nÃÉand borrow from nÃÉother banks to adjust their short-term liquidity needs. By recurring to computer simulations, we show that bilateral netting considerably reduce the potential for default cascades over an interbank network whenever the source of contagion is a negative shock to the assets of a randomly chosen bank. When the shock hits the liability side of the balance sheet nÃÉas a run on deposits nÃÉthe role of a bilateral netting agreement in mitigating the risk of a systemic liquidity crisis depends critically on the topological characteristics of the interbank network, however.