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Systemic risk, interbank relations and liquidity provision by the Central Bank

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  • Xavier Freixas

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  • Bruno Parigi
  • Jean Charles Rochet

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 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 Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 440.

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Date of creation: Oct 1998
Date of revision: Sep 1999
Handle: RePEc:upf:upfgen:440

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Web page: http://www.econ.upf.edu/

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Keywords: Systemic risk; Central Bank; prudential regulation; interbank markets; payment systems;

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  1. Bhattacharya, Sudipto & Fulghieri, Paolo, 1994. "Uncertain liquidity and interbank contracting," Economics Letters, Elsevier, vol. 44(3), pages 287-294.
  2. De Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic risk: A survey," Working Paper Series 0035, European Central Bank.
  3. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  4. 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.
  5. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  6. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  7. Scott Freeman, 1993. "Clearinghouse banks and banknote over-issue," Research Paper 9326, Federal Reserve Bank of Dallas.
  8. Freixas, Xavier & Parigi, Bruno, 1998. "Contagion and Efficiency in Gross and Net Interbank Payment Systems," Journal of Financial Intermediation, Elsevier, vol. 7(1), pages 3-31, January.
  9. Mark J. Flannery, 1996. "Financial crises, payment system problems, and discount window lending," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 804-831.
  10. Franklin Allen & Douglas Gale, 2000. "Financial Contagion," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 1-33, February.
  11. 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.
  12. Steven C. Salop, 1979. "Monopolistic Competition with Outside Goods," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 141-156, Spring.
  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. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  15. 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.
  16. 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.
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