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

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  • Freixas, Xavier
  • Parigi, Bruno
  • Rochet, Jean Charles

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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Bibliographic Info

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

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References

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  1. De Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic risk: A survey," Working Paper Series 0035, European Central Bank.
  2. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-62, November.
  3. Franklin Allen & Douglas Gale, 2000. "Financial Contagion," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 1-33, February.
  4. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  5. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  6. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  7. Xavier Freixas & Bruno Parigi, 1996. "Contagion and efficiency in gross and net interbank payment systems," Economics Working Papers 176, Department of Economics and Business, Universitat Pompeu Fabra, revised Jun 1996.
  8. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  9. Bhattacharya, Sudipto & Fulghieri, Paolo, 1994. "Uncertain liquidity and interbank contracting," Economics Letters, Elsevier, vol. 44(3), pages 287-294.
  10. Brimmer, Andrew F, 1989. "Distinguished Lecture on Economics in Government: Central Banking and Systemic Risks in Capital Markets," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 3-16, Spring.
  11. Steven C. Salop, 1979. "Monopolistic Competition with Outside Goods," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 141-156, Spring.
  12. Peter M. Garber, 1998. "Notes on the Role of TARGET in a Stage III Crisis," NBER Working Papers 6619, National Bureau of Economic Research, Inc.
  13. 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.
  14. Scott Freeman, 1993. "Clearinghouse banks and banknote over-issue," Research Paper 9326, Federal Reserve Bank of Dallas.
  15. Flannery, Mark J, 1996. "Financial Crises, Payment System Problems, and Discount Window Lending," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 804-24, November.
  16. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Correlatedness and interconnectedness risks in bank failures
    by noreply@blogger.com (Gulzar Natarajan) in Urbanomics on 2014-08-03 04:45:00
  2. Financial Interconnectedness and Systemic Risk: The Fed’s FR Y-15
    by Gerald Epstein in Triple Crisis on 2014-07-14 12:00:28
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