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.
- Lenders with more bargaining power than their borrowers are able to negotiate higher interest rates.
- Lenders with outside options (that is, access to a central bank’s IOER facility) charge higher interest rates (about 10 basis points higher on average) for overnight loans compared with lenders without access to the IOER facility.
- Negotiated interest rates are more sensitive to the bargaining power of the lender bank if that institution has no outside investment options.
- Bilateral interest rates can fall below the IOER rate if the bargaining power of the lender is sufficiently weak. Opportunity for arbitrage can arise when these lender banks persistently provide funds at rates below the IOER rate, which in turn can create a segmentation of prices for central bank reserves in the interbank market.
- Lender banks with a well-diversified lending network that provide credit to borrower banks lacking a well-diversified borrowing network exhibit the strongest bargaining power in the authors’ sample. However, the effects of heterogeneous bargaining power are less pronounced when large excess reserves are held in the banking sector.
As a consequence of the segmentation in the interbank market, some banks face substantially different financing costs compared with the one suggested by the official average effective overnight rate. For the transmission of monetary policy, it is important to consider (using transaction-level data), this variation and the bargaining-power heterogeneity that leads to it.
The authors’ findings are also relevant to the discussion of the optimal counterparty framework for the conduct of monetary policy, because the bargaining power of direct counterparties of the central bank in monetary operations will affect the transmission of monetary policy measures to broader financial markets and the economy. For example, banks with little bargaining power and no outside investment options could have difficulty passing on favorable credit conditions to the nonfinancial sector, thereby competing with the effect of monetary policy on real economic outcome variables.
The results concerning heterogeneous bargaining power and the supply of excess reserves carry implications for determining the optimal size of central banks’ balance sheets when policy rates move away from their current low levels. The authors’ finding that the impact of such heterogeneity on the pricing of interbank loans decreases when the supply of central bank reserves is large suggests a relatively large balance sheet (with a rate floor) is in order if the objective is to contain the variation in bilateral interest rates.
We study the role of bargaining power and outside options with respect to the pricing of over-the-counter interbank loans using a bilateral Nash bargaining model, and we test the model predictions with detailed transaction-level data from the euro-area interbank market. We find that lender banks with greater bargaining power over their borrowers charge higher interest rates, while the lack of alternative investment opportunities for lenders lowers bilateral interest rates. Moreover, we find that when lenders that are not eligible to earn interest on excess reserves (IOER) lend funds to borrowers with access to the IOER facility, they do so at rates that are below the IOER rate; in turn, these borrowers put the funds in their reserve accounts to earn the spread. Our findings highlight that this persistent arbitrage opportunity is not merely a result of the lack of alternative outside options for some lenders, but rather it crucially depends on lenders’ limited bilateral bargaining power, leading to a persistent segmentation of prices in the euro-area interbank market. We examine the implications of these findings for the transmission of euro-area monetary policy.