Systemic Instability of the Interbank Credit Market - A Contribution to a Resilient Financial System

Thomas Gries and Alexandra Mitschke ()
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Alexandra Mitschke: University of Paderborn

No 75, Working Papers Dissertations from Paderborn University, Faculty of Business Administration and Economics

Abstract: Interbank markets have infrequently exhibited sudden interest rate spikes. These disruptions in a key financial market can undermine financial stability. Imperfections, such as moral hazard, financial frictions, and negative externalities have been suggested as potential explanations for interbank market disruptions. However, we still know very little how the interbank market works (Allen et al., 2018). We complement traditional stock analyses by modeling dynamics in the interbank credit market, focusing on the flow process between lending and borrowing institutions. In our theoretical model credit supply is restricted by the availability of stochastic liquidity inflows to lending institutions. Following a shock in the form of an increase in volatility of these liquidity inflows, a sequential flow adjustment process sets in. In "normal times" the flow dynamics remain smooth within a stable adjustment regime. However, a higher volatility can change the lending process, resulting in a bifurcation of the equilibrium. Defining interbank "market resilience" as the probability of remaining in the stable regime, we examine the impact of monetary policy tightening on interbank market stability. A change in the volatility of reserve flows, which is more likely when central banks tighten monetary policy, may threaten the resilience of interbank markets and increase the probability of the market to fall into a regime of unstable dynamics. Thus, we stress that tightening monetary policy could incidentally reduce interbank market resilience up to a potential market collapse, even in the absence of contagion phenomena.

Keywords: Financial Markets; Interbank Lending; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E44 E52 G11 G21 (search for similar items in EconPapers)
Pages: 34
Date: 2021-04
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Related works:
Working Paper: Systemic instability of the interbank credit market: A contribution to a resilient financial system (2019)
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