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Systemic Instability of the Interbank Credit Market - A Contribution to a Resilient Financial System

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  • Thomas Gries

    (University of Paderborn)

  • Alexandra Mitschke

    (University of Paderborn)

Abstract

Interbank markets have infrequently exhibited sudden interest rate spikes. These disruptions in a key financial market can undermine financial stability. Imperfections, such as moral hazard, financial frictions, and negative externalities have been suggested as potential explanations for interbank market disruptions. However, we still know very little how the interbank market works (Allen et al., 2018). We complement traditional stock analyses by modeling dynamics in the interbank credit market, focusing on the flow process between lending and borrowing institutions. In our theoretical model credit supply is restricted by the availability of stochastic liquidity inflows to lending institutions. Following a shock in the form of an increase in volatility of these liquidity inflows, a sequential flow adjustment process sets in. In "normal times" the flow dynamics remain smooth within a stable adjustment regime. However, a higher volatility can change the lending process, resulting in a bifurcation of the equilibrium. Defining interbank "market resilience" as the probability of remaining in the stable regime, we examine the impact of monetary policy tightening on interbank market stability. A change in the volatility of reserve flows, which is more likely when central banks tighten monetary policy, may threaten the resilience of interbank markets and increase the probability of the market to fall into a regime of unstable dynamics. Thus, we stress that tightening monetary policy could incidentally reduce interbank market resilience up to a potential market collapse, even in the absence of contagion phenomena.

Suggested Citation

  • Thomas Gries & Alexandra Mitschke, 2021. "Systemic Instability of the Interbank Credit Market - A Contribution to a Resilient Financial System," Working Papers Dissertations 75, Paderborn University, Faculty of Business Administration and Economics.
  • Handle: RePEc:pdn:dispap:75
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    More about this item

    Keywords

    Financial Markets; Interbank Lending; Monetary Policy;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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