Intermediation in the Interbank Lending Market

Abstract

This paper studies systemic risk in the interbank market. We first establish that in the German interbank lending market, a few large banks intermediate funding flows between many smaller periphery banks and that shocks to these intermediary banks in the financial crisis spill over to the activities of the periphery banks. We then develop a network model in which banks trade off the costs and benefits of link formation to explain these patterns. The model is structurally estimated using banks' preferences as revealed by the observed network structure in the precrisis period. It explains why the interbank intermediation arrangement arises, estimates the frictions underlying the arrangement, and quantifies how shocks are transmitted across the network. Model estimates based on precrisis data successfully predict changes in networklinks and in lending arising from the crisis in out-of-sample tests. Finally, we quantify the systemic risk of a single intermediary and the impact of ECB funding in reducing this risk through model counterfactuals.

Payment System Externalities

“…Empirically, Ashcraft, McAndrews, and Skeie (2009) present a detailed analysis of the interbank market, and show that large banks typically borrow from small banks and do so as a result of liquidity shocks that arise due to large value transfers. Craig and Ma (2021) show that, in the German interbank market, some banks are persistent borrowers and others are persistent lenders, consistent with our model.…”

Who Can Tell Which Banks Will Fail?

“…Iyer and Peydró (2011) test financial contagion due to interbank linkages and Iyer et al (2014) study the real effects of interbank market distress. Similarly, Craig and Ma (2020) study systemic risk in the contemporary German interbank market. Afonso et al (2011) study the interbank market in the U.S. during the 2007-09 financial crisis.…”

“…Subsets of the data have been used before, e.g. byJames (1984),Ferguson and Temin (2003),Schnabel (2004Schnabel ( , 2009,Adalet (2009) andCollet and Postel-Vinay (2021).12 Note that we report the distribution of some of the core characteristics in Figure A.14 in the Appendix.13 TableA.1 provides information on the largest 40 banks.14 This contrasts with the contemporary German interbank market for which, from 2005-2009, the bulk of interbank loans was longer term (seeCraig and Ma, 2020).…”

The Federal Funds Market over the 2007-09 Crisis

“…Other related papers include those that analyze the interaction of a crisis with relationship lending (for example, see Cocco, Gomes, and Martins (2009) and Bolton et al (2016)) and network formation (for example, see Craig and Ma (2018) and Kim (2017)). Although the intermediary-based lending arrangements studied in this paper can be interpreted as relationship lending, the focus here is not on comparing interbank lending done via relationships to interbank lending of a more transactional nature.…”