Interbank lending and systemic risk

TLDR

Systemic risk arises when a bank’s distress spreads to linked agents through financial transactions, and authorities mitigate it by providing implicit insurance on interbank claims or by limiting interbank activity and centralizing liquidity management. The study examines whether decentralized interbank interactions can remain flexible while shielding central banks from rescue operations, deriving optimal prudential rules and assessing how interbank monitoring affects banks’ solvency, liquidity, and the propagation of liquidity shocks. The authors construct a model where decentralized interbank lending is driven by peer monitoring, from which they derive optimal prudential rules and conditions under which a Too‑Big‑to‑Fail policy is warranted. © 1996 Ohio State University Press; abstract borrowed from another version.

Abstract

Systemic risk refers to the propagation of a bank's economic distress to other economic agents linked to that bank through financial transactions. Banking authorities often prevent systemic risk through an implicit insurance of interbank claims, or by reducing interbank transactions and centralizing banks' liquidity management. This paper investigates whether the flexability afforded by decentralized bank interactions can be preserved while protecting the central banks from the necessity of conducting undesired rescue operations. It develops a model in which decentralized interbank leading is motivated by peer monitoring. In this context, the paper derives the optimal prudential rules, and, in particular, looks at the impact of interbank monitoring on the solvency and liquidity ratios of borrowing and lending banks. Last, it provides conditions which a Too Big To Fail policy is or is not justified and studies the possibility of propagation of a bank's liquidity shock throughout the financial system. Copyright 1996 by Ohio State University Press. (This abstract was borrowed from another version of this item.)