Trading Partners in the Interbank Lending Mark
49 Pages Posted: 19 Mar 2012
Date Written: March 15, 2012
We examine the relevance of search costs and the transmission of liquidity shocks in the US overnight interbank market. There is large and persistent heterogeneity in how banks transact in this market: while some banks mainly rely on spot transactions, most form stable relationships with at least one lending counterparty. Our results suggest that borrowers pay lower prices and borrow more from their concentrated lenders. To assess the importance of search frictions and bargaining power, we exploit idiosyncratic demand shocks and exogenous supply shocks. On days when banks have higher idiosyncratic demand for funds, they borrow more from their most concentrated lenders but pay slightly higher interest rates on these days. While idiosyncratic demand shocks are not transmitted to the rest of the market (there is no impact on the market wide interest rate or liquidity), concentrated lenders do take advantage of increased market power. In contrast, exogenous shocks to the supply of liquidity, as proxied for by days with low government sponsored enterprise lending, lead to a market wide drop in liquidity and a rise in interest rates. However, borrowers with more concentrated trading partners are able to insulate themselves almost completely from the shock.
Keywords: interbank lending, OTC markets, fed funds
JEL Classification: G21, G10, D40, E59
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