Interbank connections,contagion and bank distress in the Great Depression✰

Liquidity shocks transmitted through interbank connections contributed to bank distress during the Great Depression. New data on interbank connections reveal that banks were vulnerable to closures of their correspondents and their respondents. Further, banks were less responsive to network liquidity risk in their management of cash and capital buffers after the Federal Reserve was established, suggesting that banks expected the Fed to reduce that risk. The Fed's presence weakened incentives for the most systemically important banks to maintain capital and cash buffers against liquidity risk, and thereby likely contributed to the banking system's vulnerability to contagion during the Depression.     

Stressed,Not Frozen: The Federal Funds Market in the Financial Crisis

We examine the importance of liquidity hoarding and counterparty risk in the U.S. overnight interbank market during the financial crisis of 2008. Our findings suggest that counterparty risk plays a larger role than does liquidity hoarding: the day after Lehman Brothers' bankruptcy, loan terms become more sensitive to borrower characteristics. In particular, poorly performing large banks see an increase in spreads of 25 basis points, but are borrowing 1% less, on average. Worse performing banks do not hoard liquidity. While the interbank market does not freeze entirely, it does not seem to expand to meet latent demand.     

Money and liquidity in financial markets

We argue that there is a connection between the interbank market for liquidity and the broader financial markets, which has its basis in demand for liquidity by banks. Tightness in the market for liquidity leads banks to engage in what we term “liquidity pull-back,” which involves selling financial assets either by banks directly or by levered investors. Empirical tests on the stock market are supportive. Tighter interbank markets are associated with relatively more volume in more liquid stocks; selling pressure, especially in more liquid stocks; and transitory negative returns. We control for market-wide uncertainty and in the process also contribute to the literature on portfolio rebalancing. Our general point is that money matters in financial markets.     

Liquidity Coinsurance and Bank Capital

Banks can deal with their liquidity risk by holding liquid assets (self‐insurance), by participating in interbank markets (coinsurance), or by using flexible financing instruments, such as bank capital (risk sharing). We use a simple model to show that undiversifiable liquidity risk, that is, the liquidity risk that banks are unable to coinsure on interbank markets, represents an important risk factor affecting their capital structures. Banks facing higher undiversifiable liquidity risk hold more capital. We posit that, empirically, banks that are more exposed to undiversifiable liquidity risk are less active on interbank markets. Therefore, we test for the existence of a negative relationship between bank capital and interbank market activity and find support in a large sample of U.S. commercial banks.     

Bank loan supply responses to Federal Reserve emergency liquidity facilities

The Federal Reserve injected unprecedented liquidity into banks during the recent crisis through the discount window and Term Auction Facility. We examine the use and effectiveness of these facilities. We find that recipient banks increased their lending overall, both short- and long-term, and in most loan categories. The facilities resulted in enhanced lending at expanding banks and reduced declines at contracting banks. Small banks increased small business lending and large banks increased large business lending. There were no significant changes in loan quality or loan contract terms by either large or small banks.     

Credit risk transfer and contagion

Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises.     

Assessing financial contagion in the interbank market: Maximum entropy versus observed interbank lending patterns

Interbank markets allow banks to cope with specific liquidity shocks. At the same time, they may represent a channel for contagion as a bank default may spread to other banks through interbank linkages. This paper analyses how contagion propagates within the Italian interbank market using a unique data set including actual bilateral exposures. Based on the availability of information on actual bilateral exposures for all Italian banks, the results obtained by assuming the maximum entropy are compared with those reflecting the observed structure of interbank claims. The comparison indicates that, under certain circumstances, depending on the structure of the interbank linkages, the recovery rates of interbank exposures and banks’ capitalisation, the maximum entropy approach overrates the scope for contagion.     

Banks' Liquidity and the Cost of Liquidity to Corporations

We consider the liquidity shock banks experienced following the collapse of the asset‐backed commercial paper (ABCP) market in the fall of 2007 to investigate whether banks' liquidity conditions affect their ability to provide liquidity to corporations. We find that banks that borrowed more from the Federal Home Loan Bank system or the Federal Reserve's discount window following that liquidity shock passed a larger portion of their borrowing costs onto corporations seeking access to liquidity when compared to the precrisis period. This increase is larger among banks with a bigger exposure to the ABCP market, credit lines that pose more liquidity risk to banks, and borrowers that are likely dependent on the credit‐line provider. Our findings show that the crisis that affected the banking system had a negative effect not only on the price of credit to corporations, but also on the price corporations pay to guarantee access to liquidity.     

Bank Mergers, Competition, and Liquidity

We model the impact of bank mergers on loan competition, reserve holdings, and aggregate liquidity. A merger changes the distribution of liquidity shocks and creates an internal money market, leading to financial cost efficiencies and more precise estimates of liquidity needs. The merged banks may increase their reserve holdings through an internalization effect or decrease them because of a diversification effect. The merger also affects loan market competition, which in turn modifies the distribution of bank sizes and aggregate liquidity needs. Mergers among large banks tend to increase aggregate liquidity needs and thus the public provision of liquidity through monetary operations of the central bank.     

Discount window borrowing,monetary policy,and the post-October 6, 1979 federal reserve operating procedure

A demand schedule for discount window borrowing based on profit-maximizing bank behavior is derived. A feature of non-price rationing at the discount window making longer duration borrowing more costly is shown to make lagged borrowing and expected future spreads between the Federal funds rate and the discount rate relevant to the current borrowing decision. Consequently, both the size of the coefficients in the borrowing functions as well as the form of the function itself depend on expected Fed policy toward the spread. The demand function for discount window borrowing provides the critical link by which non-borrowed reserve control affects short-term interest rates and ultimately the money supply under post-October 6, 1979 reserve targeting. The analysis suggests some reasons why the Fed has experienced difficulty in specifying, estimating, and utilizing a discount window borrowing function in the non-borrowed reserve operating procedure.     

The interbank market after the financial turmoil: Squeezing liquidity in a “lemons market” or asking liquidity “on tap”

After August 2007 the plumbing system that supplied banks with wholesale funding, the interbank market, failed because toxic assets obstructed the pipes. Banks were forced to squeeze liquidity in a “lemons market” or to ask for liquidity “on tap” from central banks. This paper disentangles the two components of the 3-month Euribor–Eonia swap spread, credit and liquidity risk and then evaluates the decomposition. The main finding is that credit risk increased before the key events of the crisis, while liquidity risk was mainly responsible for the subsequent increases in the Euribor spread and then reacted to the systemic responses of the central banks, especially in October 2008. Moreover, the level of the spread between May 2009 and February 2010 was influenced mainly by credit risk, suggesting that European banks were still in a “lemons market” and relied on liquidity “on tap” even before sovereign debt crisis unfolded in Europe.     

The performance of banks around the receipt and repayment of TARP funds: Over-achievers versus under-achievers

In this paper, we look at how the pre-crisis health of banks is related to the probability of receiving and repaying TARP capital. We find that financial performance characteristics that are related to the probability of receiving TARP funds differ for the healthiest (“over-achiever”) versus the least healthy (“under-achiever”) banks. We find that TARP under-achievers have some, but not consistent, weaknesses in income production. These banks also are experiencing liquidity issues as customers, shut out of public debt markets, get bank loans through drawdowns of loan commitments. Unlike TARP under-achievers, TARP over-achievers’ loans are performing well. Yet, liquidity issues (from low levels of liquid assets and core deposits and drawdowns of loan commitments) hurt the abilities of these banks to continue their lending. Differences between under-achiever and over-achiever banks are also found for repayment and deadbeat TARP banks.     

中国银行业系统流动性风险考察与控制——基于资产抛售价格视角

基于银行业在宏观风险来临时出现的流动性不足和系统性风险,通过建立 DSGE-VAR 模型,考量银行业在宏观经济运行框架下的系统流动性风险,结果发现:银行同业借贷、其他证券资产和交易性负债业务的综合作用会使得银行系统流动性风险总体增大,银行如果想要降低存款提取率对其流动性的影响,就要在银行间市场停止拆出资金、出售政府证券及其他流动资产,并出售潜在的流动性较低的资产.从监管层面来讲,应当通过监管的引导效应将交易性负债进行转化,引导同业借贷和其他证券资产业务向平衡区域集中,并在一定范围内减少银行其他证券资产业务的规模.     

Can banks default overnight? Modelling endogenous contagion on the O/N interbank market

We propose a new model of the liquidity-driven banking system focusing on overnight interbank loans. This significant branch of the interbank market is commonly neglected in the banking system modelling and systemic risk analysis. We construct a model where banks are allowed to use both the interbank and the securities markets to manage their liquidity demand and supply as driven by prudential requirements in a volatile environment. The network of interbank loans is dynamic and simulated every day. We show how the intrasystem cash fluctuations alone, without any external shocks, may lead to systemic defaults, and what may be a symptom of the self-organized criticality of the system. We also analyze the impact of different prudential regulations and market conditions on the interbank market resilience. We confirm that the central bank’s asset purchase programmes, limiting the declines in government bond prices, can successfully stabilize banks’ liquidity demands. The model can be used to analyze the interbank market impact of macroprudential tools.     

Interbank market liquidity and central bank intervention

We develop a simple model of the interbank market where banks trade a long term, safe asset. When there is a lack of opportunities for banks to hedge idiosyncratic and aggregate liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. It can be constrained efficient for banks to hoard liquidity and stop trading with each other if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand.     

Bank liquidity,the maturity ladder,and regulation

We investigate the liquidity management of 62 Dutch banks between January 2004 and March 2010, when these banks were subject to a liquidity regulation that is very similar to Basel III’s Liquidity Coverage Ratio (LCR). We find that most banks hold more liquid assets against their stock of liquid liabilities, such as demand deposits, than strictly required under the regulation. More solvent banks hold fewer liquid assets against their stock of liquid liabilities, suggesting an interaction between capital and liquidity buffers. However, this interaction turns out to be weaker during a crisis. Although not required, some banks consider cash flows scheduled beyond 1 month ahead when setting liquidity asset holdings, but they seldom look further ahead than 1 year.     

On the efficiency of bilateral interbank insurance

This paper studies banks’ incentives to engage in liquidity cross-insurance. In contrast to previous literature we view interbank insurance as the outcome of bilateral (and non-exclusive) contracting between pairs of banks and ask whether this outcome is socially efficient. Using a simple model of interbank insurance we find that this is indeed the case when insurance takes place through pure transfers. This is even though liquidity support among banks sometimes breaks down, as observed in the crisis of 2007–2008. However, when insurance is provided against some form of repayment (such as is the case, for example, with credit lines), banks have a tendency to insure each other less than the socially efficient amount. We show that efficiency can be restored by introducing seniority clauses for interbank claims or through subsidies that resemble government interbank lending guarantees.     

(In)Efficient Interbank Networks

We study the efficiency properties of the formation of an interbank network. Banks face a trade-off by establishing connections in the interbank market. On the one hand, banks improve the diversification of their liquidity risk and therefore can obtain a higher expected payoff. On the other hand, banks not sufficiently capitalized have risk-shifting incentives that expose them to the risk of bankruptcy. Connecting to such risky banks negatively affects expected payoff. We show that both the optimal and the decentralized networks are characterized by a core-periphery structure. The core is made of the safe banks, whereas the periphery is populated by the risky banks. Nevertheless, the two network structures coincide only if counterparty risk is sufficiently low. Otherwise, the decentralized network is underconnected as compared to the optimal one. Finally, we analyze mechanisms that can avoid the formation of inefficient interbank networks.     

The term structure of interbank risk

We infer a term structure of interbank risk from spreads between rates on interest rate swaps indexed to the London Interbank Offered Rate (LIBOR) and overnight indexed swaps. We develop a tractable model of interbank risk to decompose the term structure into default and non-default (liquidity) components. From August 2007 to January 2011, the fraction of total interbank risk due to default risk, on average, increases with maturity. At short maturities, the non-default component is important in the first half of the sample period and is correlated with measures of funding and market liquidity. The model also provides a framework for pricing, hedging, and risk management of interest rate swaps in the presence of significant basis risk.     

Discipline and Liquidity in the Interbank Market

Using 20 years of panel data, I demonstrate that high-risk banks have consistently paid more than safe banks for interbank loans and have been less likely to use these loans as a source of liquidity. The economic importance of this effect was relatively small until the mid-1990s, when regulatory and institutional changes began to impose more of the costs of bank failure on uninsured creditors. Subsequently, interbank-market price discipline roughly doubled, and risk-based rationing effects increased by a factor of six. In imposing this discipline, lenders seem to care most about credit risk at borrowing institutions.