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Knightian uncertainty and interbank lending


  • Matthew Pritsker


The bursting of the housing price bubble during 2007 and 2008 was accompanied by high interbank spreads, and a partial breakdown of interbank lending. This paper theoretically models how Knightian uncertainty over banks risk exposures may have contributed to the breakdown. The paper shows: 1) the two-tier structure of the U.S. Fed Funds market makes it robust to uncertainty, but the market may nevertheless collapse — and private incentives to restart it may be insufficient. 2) In some circumstances government bank audits and information releases about exposures that resemble a stress test can restart markets and improve welfare by internalizing an externality associated with economy-wide uncertainty reduction. 3) Collapses due to uncertainty are less likely ex-ante and less costly to fix ex-post when there is better publicly available information on core banks aggregate risk exposures. Based on 2) and 3), ex-ante and ex-post “transparency initiatives” are proposed. Their success depends on the financial architecture of bank interlinkages.

Suggested Citation

  • Matthew Pritsker, 2012. "Knightian uncertainty and interbank lending," Risk and Policy Analysis Unit Working Paper RPA 12-4, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbqu:rpa12-4

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    References listed on IDEAS

    1. Heider, F. & Hoerova, M. & Holthausen, C., 2009. "Liquidity Hoarding and Interbank Market Spreads : The Role of Counterparty Risk," Discussion Paper 2009-40 S, Tilburg University, Center for Economic Research.
    2. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
    3. Adam Ashcraft & James Mcandrews & David Skeie, 2011. "Precautionary Reserves and the Interbank Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 311-348, October.
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    Cited by:

    1. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
    2. Maryam Farboodi, 2014. "Intermediation and Voluntary Exposure to Counterparty Risk," 2014 Meeting Papers 365, Society for Economic Dynamics.
    3. Pritsker, Matthew, 2013. "Knightian uncertainty and interbank lending," Journal of Financial Intermediation, Elsevier, vol. 22(1), pages 85-105.

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    Risk ; Banks and banking ; Interbank market ; Federal funds market (United States);

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