Working Paper

A dynamic network model of the unsecured interbank lending market


Abstract: The unsecured interbank lending market plays a crucial role in financing business activity, a fact underscored by the market's disruption following the Lehman Brothers failure in September 2008. This event, a defining moment in the global financial crisis, fostered greater uncertainty about counterparty risk, an adverse shock that severely curtailed credit supply, hampered monetary policy, and negatively impacted the real economy. To counteract the consequences of the crisis, central banks became the primary intermediaries for a large portion of the money market. However, a single main counterparty reduces the incentives for peer monitoring and the market discipline obtained from private information about counterparty credit risk. To assess the benefits gained from having a decentralized market, this paper builds and estimates a dynamic network model of interbank lending using transaction-level data. The analysis focuses on assessing the roles that credit-risk uncertainty and private information, gathered through peer monitoring and repeated interactions, play in shaping the network of bilateral lending relationships, interest rates, loan volumes, and the liquidity allocation among banks. The paper also analyzes how changes in the central bank's interest rate corridor affect the interbank market structure.

Keywords: interbank liquidity; financial networks; credit-risk uncertainty; peer monitoring; monetary policy; trading relationships; indirect parameter estimation;

JEL Classification: C33; C51; E52; G01; G21;

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Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Working Papers

Publication Date: 2016-04-01

Number: 16-3

Pages: 68 pages