Working Paper: CEPR ID: DP2325
Authors: Xavier Freixas; Bruno Parigi; Jean-Charles Rochet
Abstract: We model systemic risk in an interbank market. Banks face liquidity needs as consumers are uncertain about where they need to consume. Interbank credit lines allow banks to cope with these liquidity shocks while reducing the cost of maintaining reserves. However, the interbank market exposes the system to a coordination failure (gridlock equilibrium) even if all banks are solvent. When one bank is insolvent, the stability of the banking system is affected in various ways depending on the patterns of payments across locations. We investigate the ability of the banking industry to withstand the insolvency of one bank and whether the closure of one bank generates a chain reaction on the rest of the system. We analyze the coordinating role of the Central Bank in preventing payments' systemic repercussions and we examine the justification of the 'too-big-to-fail-policy'.
Keywords: liquidity; coordination; payment system; interbank market
JEL Codes: E58; G10; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interbank credit lines (G21) | cost of holding liquid assets (G19) |
| depositor expectations (G21) | bank stability (G28) |
| central bank intervention (E58) | market stability (D53) |
| closure of one bank (G21) | liquidation of solvent banks (G33) |