Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank

Article excerpt

THE POSSIBILITY OF A SYSTEMIC CRISIS affecting the major financial markets has raised regulatory concern all over the world. Whatever the origin of a financial crisis, it is the responsibility of the regulatory body to provide adequate fire walls for the crisis not to spill over other institutions. In this paper we explore the possibilities of contagion from one institution to another that can stem from the existence of a network of financial contracts. These contracts are essentially generated from three types of operations: the payments system, the interbank market, and the market for derivatives.(1) Since these contracts are essential to the financial intermediaries' function of providing liquidity and risk sharing to their clients, the regulating authorities have to set patterns for central bank intervention when confronted with a systemic shock. In recent years, the 1987 stock market crash, the Saving and Loans crisis, the Mexican, Asian, and Russian crises and the crisis of the Long-Term Capital Management hedge fund have all shown the importance of the intervention of the central banks and of the international financial institutions in affecting the extent, contagion, patterns, and consequences of the crises.(2)

In contrast to the importance of these issues, theory has not succeeded yet in providing a convenient framework to analyze systemic risk so as to derive how the interbank markets and the payments system should be structured and what the lender of last resort (LOLR) role should be.

A good illustration of the wedge between theory and reality is provided by the deposits shift that followed the distress of Bank of Credit and Commerce International (BCCI). In July 1991, the closure of BCCI in the United Kingdom made depositors with smaller banks switch their funds to the safe haven of the big banks, the so-called "flight to quality" (Reid 1991). Theoretically this should not have had any effect because big banks should have immediately lent again these funds in the interbank market and the small banks could have borrowed them. Yet the reality was different: the Bank of England had to step in to encourage the large clearers to help those hit by the trend. Some packages had to be agreed upon (as the 200 million [pounds sterling] to the National Home Loans mortgage lender), thus supplementing the failing invisible hand of the market. So far theory has not been able to explain why the intervention of the LOLR in this type of events was important.

Our motivation to analyze a model of systemic risk stems from both the lack of a theoretical setup, and the lack of consensus on the way the LOLR should intervene. In this paper we analyze interbank networks, focusing on possible liquidity shortages and on the coordinating role of the financial authorities--which we refer to as the central bank for short--in avoiding and solving them. To do so we construct a model of the payment flows that allows us to capture in a simple fashion the propagation of financial crises in an environment where both liquidity shocks and solvency shocks affect financial intermediaries that fund long-term investments with demand deposits.

We introduce liquidity demand endogenously by assuming that depositors are uncertain about where they have to consume. This provides the need for a payments system or an interbank market.(3) In this way we extend the model of Freixas and Parigi (1998) to more than two banks, to different specifications of travel patterns and consumers' preferences. The focus of the two papers is different. Freixas and Parigi consider the trade-off between gross and net payments systems. In the current paper we concentrate instead on system-wide financial fragility and central bank policy issues. This paper is also related to Freeman (1996a,b). In Freeman, demand for liquidity is driven by the mismatch between supply and demand of goods by spatially separated agents that want to consume the good of the other location, at different times. …