Interbank Borrowing and Lending Between Financially Constrained Banks

Economic Theory, 2019, DOI:10.1007/s00199-019-01220-9

39 Pages Posted: 5 Aug 2019 Last revised: 6 Oct 2019

See all articles by Diemo Dietrich

Diemo Dietrich

Newcastle University Business School

Achim Hauck

University of Portsmouth

Date Written: July 29, 2019

Abstract

Some stylized facts about transactions among banks are not easily reconciled with coinsurance of short-term liquidity risks. In our model, interbank markets play a different role. We argue that lending to another bank can reduce a bank’s overall portfolio risk through diversification. If insolvency is costly, this diversification improves the interbank lender’s funding liquidity, boosting credit supply to nonbanks. However, diversification comes at an endogenous cost that depends on bank-specific factors of interbank borrower and lender. The model provides a framework for understanding the importance of interbank lending for aggregate credit supply and the stability of banking systems. The model’s predictions are consistent with evidence documented in the literature that other theories cannot consistently explain.

Keywords: Interbank Lending, Bank Credit Supply, Bank Stability

JEL Classification: E5, G01, G21

Suggested Citation

Dietrich, Diemo and Hauck, Achim, Interbank Borrowing and Lending Between Financially Constrained Banks (July 29, 2019). Economic Theory, 2019, DOI:10.1007/s00199-019-01220-9, Available at SSRN: https://ssrn.com/abstract=3429990

Diemo Dietrich (Contact Author)

Newcastle University Business School ( email )

5 Barrack Road
Newcastle-upon-Tyne NE1 7RU, NE1 4SE
United Kingdom

HOME PAGE: http://www.ncl.ac.uk/business-school/staff/profile/diemodietrich.html

Achim Hauck

University of Portsmouth ( email )

Portsmouth Business School
Portsmouth
United Kingdom

HOME PAGE: http://www.port.ac.uk/economics-and-finance/staff/achim-hauck.html

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