Bargaining Power and Outside Options in the Interbank Lending Market
Abstract: We study the role of bargaining power and outside options with respect to the pricing of over-the-counter interbank loans using a bilateral Nash bargaining model, and we test the model predictions with detailed transaction-level data from the euro-area interbank market. We find that lender banks with greater bargaining power over their borrowers charge higher interest rates, while the lack of alternative investment opportunities for lenders lowers bilateral interest rates. Moreover, we find that when lenders that are not eligible to earn interest on excess reserves (IOER) lend funds to borrowers with access to the IOER facility, they do so at rates that are below the IOER rate; in turn, these borrowers put the funds in their reserve accounts to earn the spread. Our findings highlight that this persistent arbitrage opportunity is not merely a result of the lack of alternative outside options for some lenders, but rather it crucially depends on lenders’ limited bilateral bargaining power, leading to a persistent segmentation of prices in the euro-area interbank market. We examine the implications of these findings for the transmission of euro-area monetary policy.
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Provider: Federal Reserve Bank of Boston
Part of Series: Working Papers
Publication Date: 2020-06-01