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Banks choose which counterparties to approach for bilateral Nash bargaining about interest rates and set monitoring efforts to mitigate asymmetric information problems about counterparty risk. Authors estimate the structural model parameters using network statistics of the Dutch unsecured overnight interbank lending market from February 2008 to April 2011.
Their estimated model shows that prevailing bank-to-bank uncertainty and peer monitoring in interaction with counterpart search generates an amplification mechanism that can generate key characteristics of interbank markets. First, banks form long-term lending relationships that are associated with improved credit conditions. Second, the lending network exhibits a sparse coreperiphery structure. Moreover, their dynamic analysis shows that shocks to credit risk uncertainty can bring down lending activity for extended periods of time.
Authors use the estimated model to discuss monetary policy implications. In particular, they show that in order to foster trading activity in unsecured interbank markets and exploit benefits from peer monitoring, an effective policy measure is to widen the bounds of the interest rate corridor. The effects of a wider corridor result from both a direct effect and a non-linear, indirect multiplier effect triggered by increased monitoring and search activity among banks.
“For future research, we believe that our framework could be used to study several interesting extensions. First, in this paper we do not study the effects of liquidity hoarding and excess liquidity on market participation and the bilateral bargaining problem and monitoring decisions.23 Second, this paper leaves open the question of the optimal corridor size, which requires assumptions on the central bank’s preferences. Third, an interesting analysis could ask how the failure of an interbank relationship lender that disposes of private information tightens credit conditions for its respective borrowers, thereby giving room to contagion from the asset side.”