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
Date Written: July 29, 2019
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: Suggested Citation