Efficiency and stability of a financial architecture with too-interconnected-to-fail institutions

The regulation of large interconnected financial institutions has become a key policy issue. To improve financial stability, regulators have proposed limiting banks' size and interconnectedness. I estimate a network-based model of the over-the-counter interbank lending market in the US and quantify the efficiency-stability implications of this policy. Trading efficiency decreases with limits on interconnectedness because the intermediation chains become longer. While restricting the interconnectedness of banks improves stability, the effect is non-monotonic. Stability also improves with higher liquidity requirements, when banks have access to liquidity during the crisis, and when failed banks' depositors maintain confidence in the banking system. (C) 2016 Elsevier B.V. All rights reserved.