Core-Periphery Formation in Interbank Markets

Abstract

Interbank markets are fundamentally important for banks' liquidity management, for the transmission of monetary policy, and also for financial stability. In order to discuss issues of financial stability, the structure of interbank markets plays a crucial role. This paper provides a model on network formation in interbank markets. Due to bank opacity, there are informational frictions in the sense that not all actions of a bank can be observed by other market participants. To collect more information, banks can establish costly relationships to other banks and thereby increase the expected benefit of an interbank transaction. The cost of such a link reveals the quality of information between banks and a bank's monitoring efficiency. Our aim is to identify network structures that satisfy efficiency or unilateral stability. In particular, we ask under which conditions core-periphery networks are efficient or unilaterally stable. Under the assumption that linking costs are homogeneous, a core-periphery network is not unilaterally stable. However, heterogeneity can explain core-periphery formation. A core-periphery network is unilaterally stable if there is a group of sufficiently better informed or more efficient banks.

Keywords: interbank markets, intermediation, core-periphery structure, network formation

JEL Classification: G14, G21