Interbank markets and their optimal regulation

Abstract

Recent years have seen interest in interbank market regulation. Unfortunately, a review of the literature in this area identifies two gaps. The first is that previous studies have tended to take the form of the interbank contract as given, making it difficult to generate convincing policy prescriptions. The second gap is that previous studies have tended to focus on ex-post policies which kick in after an interbank disruption has occurred. It's thus natural to ask if ex-ante policies have a role to play.

This dissertation takes steps toward addressing these gaps. Chapter one focuses on endogenizing the form of banks' interbank contracts, namely by developing a model in which banks choose this form as part of an optimal contracting problem. I argue that the model can account for interbank disruptions like those witnessed during the recent crisis. I also explore its predictions on the circumstances under which the economy becomes vulnerable to these disruptions, along with some policy implications. With respect to the first of these issues, I show that the in-model risk of interbank disruptions is procyclical, consistent with the view that endogenous risk tends to accumulate during good times. I then derive a ``no-go'' result on the policy front. In particular, I show that the aforementioned disruptions are constrained efficient, with no role for policy.

Chapter three extends the baseline model from chapter one to include a standard source of constrained inefficiency, namely a pecuniary externality in the capital market. In this setting, a planner's solution can be implemented using ex-ante prudential policies to regulate banks’ initial leverage and liquidity, supplemented with ex-post monetary stimulus in the event that a disruption occurs. This highlights the need for coordination between monetary policy and financial regulation. I furthermore argue that the ex-ante components do most of the heavy lifting.

Chapter two emphasizes the importance of ex-ante intervention more starkly, namely by developing an alternate extension in which pecuniary externalities arise in the deposit market. In this case, policy must take the form of an ex-ante intervention, since the interest rate on deposits is locked-in if and when interbank disruptions occur.