Interbank Market Freezes and Creditor Runs

Review of Financial Studies, Vol. 29, No. 7, 2016

63 Pages Posted: 6 Jan 2014 Last revised: 18 Sep 2016

See all articles by Xuewen Liu

Xuewen Liu

University of Hong Kong (HKU) - Finance Area, Faculty of Business and Economics

Date Written: March 9, 2016

Abstract

We model the interplay between trade in the interbank market and creditor runs on financial institutions. We show that the feedback between them can amplify a small shock into "interbank market freezing" with "liquidity evaporating". Credit crunches of the interbank market drive up the interbank rate. For an individual institution, a higher interbank rate -- meaning a higher funding cost -- results in more severe coordination problems among creditors in debt rollover decisions. Creditors thus behave more conservatively and run more often. Facing an increased chance of creditor runs, institutions demand more and supply less liquidity, tightening the interbank market. Our model helps to explain the occurrence of a crisis and amplification, demonstrating that banking crises arise from a shrinking of the pool of aggregate liquidity.

Keywords: Interbank market, creditor runs, insolvency risk, illiquidity risk, global games, general equilibrium

JEL Classification: G01; G21; D83; D53

Suggested Citation

Liu, Xuewen, Interbank Market Freezes and Creditor Runs (March 9, 2016). Review of Financial Studies, Vol. 29, No. 7, 2016, Available at SSRN: https://ssrn.com/abstract=2375037 or http://dx.doi.org/10.2139/ssrn.2375037

Xuewen Liu (Contact Author)

University of Hong Kong (HKU) - Finance Area, Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

HOME PAGE: http://web.hku.hk/~xuewenl/

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