The Role of Interbank Markets
in Monetary Policy:
A Model with Rationing
by
Xavier Freixas and José Jorge
Discussion by
George Pennacchi
University of Illinois
Outline of Discussion
1.
2.
3.
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6.
Nature of the Model’s Interbank Market
An Alternative Interbank Market
Credit Lines and Relationship Banking
Credit Line Drawdowns and Deposit Flows
Capital versus Liquidity
Conclusions
2
Comments on the Model’s Interbank Market
¾
Due to asymmetric information and strong moral hazard,
banks that need to fund firms’ lines of credit can borrow in
the interbank market only on a fully collateralized basis.
¾
This RCCM equilibrium implies an interbank market that is
limited to repurchase agreements (repos) of no more than
each bank’s pledgable collateral, K, less senior deposits, D1.
¾
The equilibrium can lead to excessive liquidation of firms’
projects if credit line drawdowns imply bank borrowing
that exceeds the interbank market’s rationing limit K-D1.
3
Collateral from a Bank’s “Private Benefits” Project
¾
It is assumed that a bank that engages in moral hazard has
a private benefits project return, K, that is known.
¾
But if the bank is “gambling for resurrection,” it may be a
strong assumption to assume its return is deterministic.
¾
If, instead, the private benefit project return were risky, so
that K is random, e.g., K ∈ ⎡⎣ 0 , K ⎤⎦ , then a credit spread
may exist in the interbank market.
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Market Segmentation
¾
To obtain a possible spread between the default-free
interbank repo rate, rL, and the default-free T-bill rate, r,
the model needs to assume market segmentation.
¾
When rL – r > 0, the banking sector has sold all of its Tbills to non-banks, but there is still a positive net
aggregate demand for line of credit liquidity at the rate r.
¾
rL rises above r because banks cannot borrow (issue
deposits) to non-banks even if it is fully collateralized.
¾
Justification? Why cannot money market mutual funds
buy repos? In practice, do general collateral repo rate
spreads rise during monetary/liquidity tightenings?
5
Modeling a Credit, rather than Liquidity, Spread
¾
Models with asymmetric information but more limited
moral hazard (Duffie and Lando Econometrica 2001,
Freixas and Holthausen RFS, 2005) might not require
the market segmentation assumption.
¾
An equilibrium with unsecured interbank lending with
defaults that increase as firms’ debt burden rises with rL
might generate similar results.
¾
However, in such a model rL - r would reflect a credit,
not liquidity, spread, as Furfine JB (2001) finds in the
Federal Funds market.
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Lines of Credit and Relationship Banking
¾
The model assumes that all firms’ interest rates on the
credit lines from their banks, rF, are the same: rF = rL.
¾
However, a firm with a profitable project may have its
credit line drawdown refused (MAC clause?) if its
bank is rationed in the interbank market.
¾
Since a bank’s probability of being rationed is inversely
related to its T-bill holdings, B0, a firm would prefer to
have its credit line at a bank with more liquid
securities, so that ∂rF /∂B0> 0.
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Line of Credit Lending and Bank Deposit Flows
¾
Deposit flows at the times of credit line drawdowns, D,
might mitigate the need for interbank borrowing.
¾
Consistent with the model of Kashyap, Rajan, and Stein
JF (2002), Gatev and Strahan JF (2006) find that large
bank deposits increased during liquidity shocks,
especially for banks with high credit line commitments.
¾
Pennacchi JME (2006) also finds flows into money
market mutual funds during liquidity shocks, largely used
to invest in wholesale bank CDs.
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Capital versus Liquid Security Holdings
¾
In the model, ceteris paribus, additional T-bill
holdings are financed with additional equity capital.
¾
However, banks can be:
1) well-capitalized but hold few liquid securities; or
2) thinly-capitalized but hold many liquid securities.
¾
There may be further insights from distinguishing
between how a bank’s capital versus its liquid security
holdings affect interbank rationing.
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Conclusions
¾
The paper’s model provides insights for an interbank
market where borrowers must pledge collateral.
¾
However, many interbank markets (Federal Funds,
Eonia, London Interbank) are unsecured.
¾
Whether interbank spreads reflect credit risks or
liquidity shortages could impact the appropriate policy
response (e.g., inject capital versus inject liquidity).
“The problems won’t go away with any of the measures that the ECB is
taking….It’s a problem of balance-sheet protection that’s keeping (longerterm) rates elevated.” - Christoph Rieger, interest rate strategist,
Dresdner Kleinwort in “ECB’s Cash Injection Fails to Tame
Rates” The Wall Street Journal 28 Nov. 2007
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