Monetary Policy Implementation in an Interbank Network: Effects on Systemic Risk

43 Pages Posted: 29 Mar 2014 Last revised: 19 Nov 2016

See all articles by Marcel Bluhm

Marcel Bluhm

The Block

Ester Faia

Goethe University Frankfurt

Jan Pieter Krahnen

Goethe University Frankfurt

Date Written: March 26, 2014

Abstract

This paper makes a conceptual contribution to the effect of monetary policy on financial stability. We develop a microfounded network model with endogenous network formation to analyze the impact of central banks' monetary policy interventions on systemic risk. Banks choose their portfolio, including their borrowing and lending decisions on the interbank market, to maximize profit subject to regulatory constraints in an asset-liability framework. Systemic risk arises in the form of multiple bank defaults driven by common shock exposure on asset markets, direct contagion via the interbank market, and firesale spirals. The central bank injects or withdraws liquidity on the interbank markets to achieve its desired interest rate target. A tension arises between the bene ficial effects of stabilized interest rates and increased loan volume and the detrimental effects of higher risk taking incentives. We fi nd that central bank supply of liquidity quite generally increases systemic risk.

Keywords: Network formation, contagion, central banks' interventions

JEL Classification: C63, D85, G01, G28

Suggested Citation

Bluhm, Marcel and Faia, Ester and Krahnen, Jan Pieter, Monetary Policy Implementation in an Interbank Network: Effects on Systemic Risk (March 26, 2014). SAFE Working Paper No. 46, Available at SSRN: https://ssrn.com/abstract=2417219 or http://dx.doi.org/10.2139/ssrn.2417219

Marcel Bluhm

The Block ( email )

New York
United States

Ester Faia (Contact Author)

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Jan Pieter Krahnen

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

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