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

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

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 system 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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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 32 (2000)
Issue (Month): 3 (August)
Pages: 611-38

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Handle: RePEc:mcb:jmoncb:v:32:y:2000:i:3:p:611-38
Contact details of provider: Web page: http://www.blackwellpublishing.com/journal.asp?ref=0022-2879

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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. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  3. Allen, Franklin & Gale, Douglas, 1998. "Financial Contagion," Working Papers 98-33, C.V. Starr Center for Applied Economics, New York University.
  4. 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.
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  6. Steven C. Salop, 1979. "Monopolistic Competition with Outside Goods," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 141-156, Spring.
  7. Xavier Freixas & Bruno Parigi, 1998. "Contagion and efficiency in gross and net interbank payment systems," Proceedings 592, Federal Reserve Bank of Chicago.
  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. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  10. 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.
  11. 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.
  12. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
  13. 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.
  14. de Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic Risk: A Survey," CEPR Discussion Papers 2634, C.E.P.R. Discussion Papers.
  15. Scott Freeman, 1993. "Clearinghouse banks and banknote over-issue," Research Paper 9326, Federal Reserve Bank of Dallas.
  16. 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.
  17. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
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