04 February 2014

New Research Paper – A Dynamic Stochastic Network Model of the Unsecured Interbank Lending Market

Work has now been completed on a SWIFT Institute research grant looking at the interbank lending market.

Authored by Francisco Blasques, Falk Bräuning and Iman Van Lelyveld, their research suggests that policies that reduce credit risk uncertainty might play an important role in fostering interbank lending and in re-establishing an active interbank market.

You can download the paper here.

A Dynamic Stochastic Network Model of the Unsecured Interbank Lending Market

Authors
Francisco Blasques – VU University Amsterdam
Falk Bräuning – VU University Amsterdam
Iman Van Lelyveld – De Nederlandsche Bank

Abstract
The interbank lending market is a market in which banks extend loans to each other. Such loans are negotiated bilaterally between banks. The interbank market is crucial for two reasons. First, it is essential for the banks’ day-to-day liquidity management. Second, the interbank lending market marks the first step of the monetary transmission mechanism which allows central banks to adjust interest rates in the economy. As such, central banks typically focus on steering interest rates in the interbank lending market as a means of altering credit conditions in the real sectors.

The drop in transaction volumes in the interbank lending market may have been a contributing factor to the financial crisis of 2007/08. In particular, worries about counterparty credit risk of banks have adversely affected credit availability in the interbank lending market and conditions in the unsecured interbank segment where loans are uncollateralized. The fear of financial contagion amplified these effects.

The research developed by Blasques, Bräuning and Van Lelyveld for the SWIFT Institute contributes to the understanding of the role that credit risk uncertainty plays in the interbank lending market. In particular, their research attempts to describe how banks may pursue monitoring activities in order to increase the information they have about their partners and ultimately reduce the risk and uncertainty associated with lending in the interbank market. As such, the interbank market is modelled as a network where banks select counterparties to approach for borrowing, negotiate trading volumes and interest rates bilaterally and acquire information to mitigate credit risk uncertainty (peer monitoring). Interbank lending between two banks is only feasible if the lender’s perceived credit risk about a borrower is sufficiently low.

The findings of this research are relevant for central bankers and financial regulators, and subsequently the banks themselves. The research suggests that policies that reduce credit risk uncertainty might play an important role in fostering interbank lending and in re-establishing an active interbank market. Specifically they find that repeated lending between banks may significantly reduce asymmetric information and improve credit conditions due to lower credit risk uncertainty. Reduction in credit risk uncertainty may thus be achieved by widening the interest rate corridor of the central bank (discount window) to increase the spread between depositing and borrowing money from the central bank. This will reduce the attractiveness and of outside options and the increased use of interbank lending will lead to more informed choices leading to lower rates.


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