A Model of Network Formation for the Overnight Interbank Market
49 Pages Posted: 17 Apr 2016 Last revised: 7 Jan 2021
Date Written: January 7, 2021
In this paper, we introduce an endogenous network formation model of the interbank overnight lending market. The banks operate within the corridor system adopted by the Central Bank and their end-of-the-day reserves are subject to random shocks. To optimize the costs of meeting the reserve requirements or handling excess liquidity, banks can enter the interbank market, where they set both loan amounts and interest rates, with lenders facing a counter-party default risk. We fully characterize equilibrium lending-borrowing networks, showing that they have a bipartite structure in which connected banks are either lenders or borrowers but not intermediaries. By aggregating lending-borrowing networks over time, we are able to reproduce the empirically observed core-periphery structure of interbank lending markets with intermediation. The model reproduces the empirical data of the e-MID market for overnight interbank transactions. We use this novel framework to discuss the effects of monetary policies, including those that aim to stabilize the interbank market.
Keywords: Network formation, pairwise stable network, overnight market, interbank loans
JEL Classification: D85, G21, L14
Suggested Citation: Suggested Citation