A Dynamic Network Model of the Unsecured Interbank Lending Market 
The unsecured interbank lending market plays a crucial role in financing business activity, a fact underscored by the market's disruption following the Lehman Brothers failure in September 2008. This event, a defining moment in the global financial crisis, fostered greater uncertainty about counterparty risk, an adverse shock that severely curtailed credit supply, hampered monetary policy, and negatively impacted the real economy. To counteract the consequences of the crisis, central banks became the primary intermediaries for a large portion of the money market. However, a single main counterparty reduces the incentives for peer monitoring and the market discipline obtained from private information about counterparty credit risk. To assess the benefits gained from having a decentralized market, this paper builds and estimates a dynamic network model of interbank lending using transaction-level data. The analysis focuses on assessing the roles that credit-risk uncertainty and private information, gathered through peer monitoring and repeated interactions, play in shaping the network of bilateral lending relationships, interest rates, loan volumes, and the liquidity allocation among banks. The paper also analyzes how changes in the central bank's interest rate corridor affect the interbank market structure.
Key Findings
- Bank pairs engage in repeated monitoring and counterparty search efforts that establish stable long-term trading relationships, which are associated with lower interest rates and improved credit availability. These peer monitoring efforts reduce bank-to-bank credit-risk uncertainty and generate a multiplier effect that has important implications for the endogenous network structure.
- Peer monitoring, search frictions, and uncertainty about counterparty risk largely explain the network's tiered core-periphery structure, characterized by a core comprised of a few highly interconnected banks that intermediate in the market and many sparsely connected peripheral banks that trade almost exclusively with the core banks. The large money center banks are more intensely monitored by their lenders, who in turn closely monitor their borrowers. These efforts garner information that reduces credit risk uncertainty, resulting in lower bid and offer rates and more granted loans. Core banks lend to each other at up to 40 basis points less than high-spread pairs.
- Adverse shocks to credit-risk uncertainty can suppress interbank lending for extended periods: the network shrinks as bilateral interest rates rise due to higher perceived counterparty risk. Given the alternative of using the central bank's lending and deposit facilities, the interbank market is less profitable so the incentives for peer monitoring and search efforts decline, and the lending network becomes more concentrated among a few banks. The reduced network connections and lower peer monitoring have a multiplier effect that further slows the recovery of the interbank lending market.
Implications
The interest rate spread between the central bank's lending and deposit facilities helps determine interbank lending activity: monetary policymakers can widen the interest rate to increase interbank market activity, generating a multiplier effect to improve credit conditions. Determining the optimal corridor width is a task for further work.