Bargaining Power and Outside Options in the Interbank Lending Market
The interest rates that banks charge to borrowers of their excess reserves in the over-the-counter (OTC) interbank market play an important role not only in liquidity reallocation and risk sharing in the banking sector, but also in the pricing of other financial assets and thus in the functioning of the financial system as a whole. Consequently, the effect of any monetary policy depends on these rates. Major central banks therefore implement their conventional monetary policy by steering an average effective level of the overnight interbank rate toward a defined target rate.
This paper questions how reliable an average effective overnight interbank rate is for the implementation of monetary policy. The authors argue that the interest rates in the OTC interbank market can vary sharply across market participants due to the alternative investment opportunities and, more importantly, the bilateral bargaining power of the lender and the borrower in a given trade, and that these variables therefore can strongly affect monetary policy implementation and its transmission to the wider economy.
To test their model’s predictions, the authors use detailed transaction-level data on euro-denominated overnight interbank loans from the Eurosystem’s payment and settlement system, TARGET2. The loan-level information allows them to examine the role of bilateral bargaining power (derived, in general, from well-diversified lending or borrowing networks) and outside options (particularly the ability to deposit reserve balances in a central bank and earn interest on excess reserves [IOER]) on interbank loan rates at the bank-pair level; it also allows them to investigate the factors driving the heterogeneity in both variables.