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Interbank borrowing and lending between financially constrained banks

Lookup NU author(s): Dr Diemo DietrichORCiD, Dr Achim Hauck

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Abstract

Some stylized facts about transactions among banks are not easily reconciled with co-insurance of short-term liquidity risks. In our model interbank markets play a different role. We argue that lending to another bank can reduce a bank's overall portfolio risk through diversification. If insolvency is costly, this diversification improves the interbank lender's funding liquidity, boosting credit supply to non-banks. However, diversification comes at an endogenous cost that depends on bank-specific factors of interbank borrower and lender. The model provides a framework for understanding the importance of interbank lending for aggregate credit supply and the stability of banking systems. The model's predictions are consistent with evidence documented in the literature that other theories cannot consistently explain.

Publication metadata

Author(s): Dietrich D, Hauck A

Publication type: Article

Publication status: Published

Journal: Economic Theory

Year: 2020

Volume: 70

Issue: 2

Pages: 347-385

Print publication date: 01/09/2020

Online publication date: 29/07/2019

Acceptance date: 20/07/2019

Date deposited: 19/07/2019

ISSN (print): 0938-2259

ISSN (electronic): 1432-0479

Publisher: Springer

URL: https://doi.org/10.1007/s00199-019-01220-9

DOI: 10.1007/s00199-019-01220-9

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