Interbank lending with benchmark rates: Pareto Optima for a Class of Singular Control Games

Abstract

We study a class of N-player stochastic differential games of singular control, motivated by the study of a dynamic model of interbank lending with benchmark rates. We describe Pareto optima for this game and show how they may be achieved through the intervention of a regulator, whose policy is a solution to a singular stochastic control problem. Pareto optima are characterized in terms of the solution to a new class of Skorokhod problems with piecewise-continuous free boundary.

Pareto optimal policies are shown to correspond to the enforcement of endogenous bounds on interbank lending rates.

Analytical comparison between Pareto optima and Nash equilibria for the case of two players allows quantifying the impact of regulatory intervention on the stability of the interbank rate.

Keywords: stochastic differential games, Pareto optimum, LIBOR, benchmark rates, interbank market

JEL Classification: C73, G18, G21