Over-the-counter loans, adverse selection, and stigma in the interbank market

It is often the case that banks in the US are willing to borrow in the fed funds market (the interbank market for funds) at higher rates than the ones they could obtain by borrowing at the Fed's discount window. This phenomenon is commonly explained as the consequence of the existence of a stigma effect attached to borrowing from the window. Most policymakers and empirical researchers consider the stigma hypothesis plausible. Yet, no formal treatment of the issue has ever been provided in the literature. In this paper, we fill that gap by studying a model of interbank credit where: (1) banks benefit from engaging in intertemporal trade with other banks and with outside investors; and (2) physical and informational frictions limit those trade opportunities. In our model, banks obtain loans in an over-the-counter market (involving search, bilateral matching, and negotiations over the terms of the loan) and hold assets of heterogeneous qualities which in turn determine their ability to repay those loans. When asset quality is not observable by outside investors, information about the actions taken by a bank in the credit market may influence the price at which it can sell its assets. In particular, under some conditions, discount window borrowing may be regarded as a negative signal about the quality of the borrower's assets. In such cases, some of the banks in our model, just as in the data, are willing to accept loans in the interbank market at higher rates than the ones they could obtain at the discount window.