Cross-Asset Holdings and the Interbank Lending Market

Recent empirical papers have found that, contrary to popular belief, wholesale funding markets did not cease to function during the subprime crisis. This paper explains this resilience through the strong interconnections between banks, which give them an incentive to subsidize each other. We specify a model in which financial institutions that share similar portfolios provide each other with favorable lending conditions in order to protect themselves against fire sales. The resulting subsidy drives rates down and leads to a more clustered interbank network, particularly during crises. The subsidy is desirable from a systemic risk perspective because it helps to limit borrower risk, although it has a positive impact on the scope for contagion.