Academic journal article Journal of Money, Credit & Banking

Does Interbank Borrowing Reduce Bank Risk?

Academic journal article Journal of Money, Credit & Banking

Does Interbank Borrowing Reduce Bank Risk?

Article excerpt

POL1CYMAKERS HAVE SHOWN considerable interest in market discipline as a supplement to bank regulation. The idea is that regulators can use market signals to identify banks that the market perceives as riskier (Berger 1991). (1) Most of the "market discipline" literature has concentrated on using traded subordinated debt and equity pricing as a market discipline tool (Morgan and Stiroh 2001, Sironi 2002, Evanoff and Wall 2001, Ashcraft 2008). In this paper, we take another approach in concentrating on interbank borrowing as a signal of risk.

Interbank exposures have often been viewed in the literature as a source of contagion (Allen and Gale 2000, Freixas, Parigi, and Rochet 2000) and, therefore, as a factor enhancing systemic risk. However, Rochet and Tirole (1996) argue that by generating incentives for lending banks to monitor interbank-borrowing banks, interbank exposures may also contribute to prudent market behavior and reduce the risk of bank failures and systemic distress. The idea is that banks are particularly good at identifying the risks of other banks. Provided with proper incentives, they can perform a complementary task to bank regulation and supervision by the authorities.

Despite the obvious appeal of this idea, empirical research on the issue is limited. In a first step in this direction, Furfine (2001) examines the pricing of interbank lending agreements as an indicator of the ability of banks to monitor their interbank borrowers. Since interbank loans in the federal funds market are large and uncollateralized, they expose lending institutions to significant credit risk. Lending banks, therefore, have an incentive to monitor their counterparties and price these loans as a function of the credit risk of the borrowing bank. (2) Furfine's empirical results support this hypothesis by showing that borrowing banks with higher profitability, higher capital ratios, and fewer problem loans pay lower interest on federal fund loans than others. However, the impact is fairly small; for example, a one standard deviation rise in the loan-to-capital ratio raises the interest rate by merely 1.5 basis points. In a more recent paper, King (2008) also finds that high-risk banks pay higher interest on federal funds. He shows, in addition, that more risky banks will borrow less in the federal funds market. Ashcraft and Bleakley (2006) point to the fact that the studies focusing on the correlation of prices with risk may confound supply and demand effects. To disentangle supply and demand effects they use exogenous shocks to a bank's liquidity position to trace out the credit supply curve. Using this approach, they document only weak evidence of the existence of market discipline.

A potential reason for the small economic significance of the results and the low empirical research interest in the issue is that the economic analysis of interbank exposures has so far concentrated on highly developed banking markets, where interbank exposures are mostly generated by short-term liquidity needs (as modeled by Bhattacharya and Gale 1987). As pointed out by Rochet and Tirole (1996), short-term interbank exposures might not be effective disciplinary tools since they can quickly be abandoned by both the borrowing and the lending banks. Furthermore, in an environment where interbank borrowers are large institutions the disciplining role of interbank borrowing may be hampered by too-big-to-fail concerns, since the interbank lenders anticipate potential bail-outs of the large interbank borrowers.

Our purpose in this paper is to document that interbank borrowing is associated with lower risk taking of borrowing banks. This phenomenon would be consistent with the market discipline hypotheses and with some type of monitoring role performed by the lending banks.

To empirically test this hypothesis we employ data from a sample of Central and Eastern European (CEE) countries, where interbank trade is the result of long-term specialization of incumbent banks in issuing deposits and of new entrant banks in lending to nonbanks. …

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