Fundamentals Matter: Idiosyncratic Shocks and Interbank Relations

Abstract

Our results uncover a so far undocumented ability of the interbank market to distinguish between banks of different quality in times of aggregate distress. We show empirical evidence that during the 2007 financial crisis the inability of some banks to roll over their interbank debt was not due to a failure of the interbank market per se but rather to bank specific shocks affecting banks' capital, liquidity and credit quality as well as revised bank-level risk perceptions. Relationship banking is not capable of containing these frictions, as hard information seems to dominate soft information. In detail, we explore determinants of the formation and resilience of interbank lending relationships by analyzing an extensive dataset comprising over 1.9 million interbank relationships of more than 3,500 German banks between 2000 and 2012.

Keywords: financial stability, interbank market, aggregate and idiosyncratic shocks, relationship banking, risk perception, market discipline

JEL Classification: E50, G01, G10, G21