Interbank Market Integration Under Asymmetric Information

Abstract

While domestic interbank markets are often considered to work in an efficient way, cross-country bank lending appears to be subject to market imperfections leading to persistent interest rate differentials. In a model where banks need to cope with liquidity shocks by borrowing or by liquidating assets, we study the scope for international interbank market integration with unsecured lending when cross-country information is noisy. We find that an equilibrium with integrated markets need not always exist, and that it coexists with one characterized by segmentation. A repo market reduces interest rate spreads and improves upon the segmentation equilibrium. However, it may destroy the unsecured integrated equilibrium, since it reduces the liquidity imbalances and thus the gains from unsecured market integration. The introduction of other transnational institutional arrangements, such as multinational banking, correspondent banking and the existence of "too-big-to-fail" banks may reduce cross country interest spreads and provide more insurance against country wide liquidity shocks. Still, multinational banking, as the introduction of repos, may threaten the integrated interbank market equilibrium.

Keywords: Interbank lending, financial integration, interbank markets, multinational banks, Too-Big-To-Fail

JEL Classification: G15, G21, F36