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Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank

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Author Info
Freixas, Xavier
Parigi, Bruno
Rochet, Jean Charles

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Abstract

We model systemic risk in an interbank market. Banks face liquidity needs as consumers are uncertain about where they need to consume. Interbank credit lines allow banks to cope with these liquidity shocks while reducing the cost of maintaining reserves. However, the interbank market exposes the system to a coordination failure (gridlock equilibrium) even if all banks are solvent. When one bank is insolvent, the stability of the banking system is affected in various ways depending on the patterns of payments across locations. We investigate the ability of the banking industry to withstand the insolvency of one bank and whether the closure of one bank generates a chain reaction on the rest of the system. We analyze the coordinating role of the Central Bank in preventing payments' systemic repercussions and we examine the justification of the 'too-big-to-fail-policy'.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2325.

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Date of creation: Dec 1999
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Handle: RePEc:cpr:ceprdp:2325

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Related research
Keywords: Coordination; Interbank Market; Liquidity; Payment System;

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Find related papers by JEL classification:
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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  7. Nobuhiro Kiyotaki & John Moore, 2004. "Credit Chains," ESE Discussion Papers 118, Edinburgh School of Economics, University of Edinburgh.
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  12. Jacklin, Charles J & Bhattacharya, Sudipto, 1988. "Distinguishing Panics and Information-Based Bank Runs: Welfare and Policy Implications," Journal of Political Economy, University of Chicago Press, vol. 96(3), pages 568-92, June. [Downloadable!] (restricted)
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  15. Bhattacharya, Sudipto & Fulghieri, Paolo, 1994. "Uncertain liquidity and interbank contracting," Economics Letters, Elsevier, vol. 44(3), pages 287-294. [Downloadable!] (restricted)
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