Simultaneity of Interbank Market Rates – Theory and Methodological Implications

Abstract

We study price formation on interbank markets. We derive insights from a theoretical model that have important implications for empirical applications. In our theoretical model banks compete on lending and deposit rates in a horizontally differentiated oligopoly. Banks have to close funding gaps or surpluses, but the model allows them to hold both interbank assets and liabilities, a behavior that has been extensively documented empirically. We show the existence of a Nash equilibrium and provide conditions for its uniqueness. The key insight from the theoretical model is that interbank lending and deposit rates are determined simultaneously. We document the presence of simultaneity in an example estimation using real-world data. We show that this simultaneity would induce an economically significant bias into the estimations and lead to flawed inference if it was not accounted for. We thus advocate testing for simultaneity when performing empirical analyses of interbank market rates or spreads.

Keywords: Interbank Market, Bertrand Oligopoly, Lehman Crisis

JEL Classification: C3, D4, G2, L2