Inefficiency of Bilateral Bargaining in Inter-Bank Markets

Abstract

Many countries have inter-bank markets that are Over The Counter (OTC) instead of exchange mediated. In OTC systems, bilateral bargaining takes place over the rate of interest on the (inter-bank) loan. This paper characterizes such bilateral bargaining for loans between banks under asymmetric information and shows that bargaining outcomes maybe inefficient. The paper suggests two sources of inefficiency. In a one period model, bargaining between two banks may fail due to incomplete information even if gains to trade exist. Inter-temporal issues examined in this paper reveals that repeated interaction could create distorting effects through reciprocal contracts. Both cases are shown to require active liquidity management by the regulatory authority in order to restore the first best allocation.

Keywords: liquidity distribution, asymmetric information, interbank markets

JEL Classification: E500, G100, G 200