Working Paper: CEPR ID: DP7762
Authors: Florian Heider; Marie Hoerova; Cornelia Holthausen
Abstract: We study the functioning and possible breakdown of the interbank market in the presence of counterparty risk. We allow banks to have private information about the risk of their assets. We show how banks' asset risk affects funding liquidity in the interbank market. Several interbank market regimes can arise: i) normal state with low interest rates; ii) turmoil state with adverse selection and elevated rates; and iii) market breakdown with liquidity hoarding. We provide an explanation for observed developments in the interbank market before and during the 2007-09 financial crisis (dramatic increases of unsecured rates and excess reserves banks hold, as well as the inability of massive liquidity injections by central banks to restore interbank activity). We use the model to discuss various policy responses.
Keywords: asymmetric information; counterparty risk; financial crisis; interbank market; liquidity
JEL Codes: D82; G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Banks' long-term asset risk (G21) | evaporation of liquidity in the unsecured interbank market (E44) |
| Low asset risk (G19) | smooth operation of interbank market (E44) |
| smooth operation of interbank market (E44) | low interest rates (E43) |
| Low asset risk (G19) | active lending (G21) |
| Increased asset risk (G19) | adverse selection (D82) |
| adverse selection (D82) | exit of safer banks from market (G21) |
| exit of safer banks from market (G21) | higher interest rates (E43) |
| high dispersion of risk (D39) | liquidity-rich banks hoarding liquidity (E51) |
| liquidity-rich banks hoarding liquidity (E51) | market breakdown (G10) |
| adverse selection and asymmetric information (D82) | breakdown in lending (G21) |