Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation

By Jean-Charles Rochet | Go to book overview

Chapter Five

Interbank Lending and Systemic Risk

Jean-Charles Rochet and Jean Tirole

Systemic risk refers to the propagation of an agent's economic distress to other agents linked to that agent through financial transactions. Systemic risk is a serious concern in manufacturing, where trade credit links producers through a chain of obligations,1 and in the insurance industry through the institution of reinsurance. The anxiety about systemic risk is perhaps strongest among bank executives and regulators. For, banks' mutual claims, which, by abuse of terminology, we will gather under the generic name of “interbank loans” or “interbank transactions,” have grown substantially in recent years. These include intraday debits on payment systems, overnight and term interbank lending in the Fed funds market or its equivalents, and contingent claims such as interest rate and exchange rate derivatives in OTC markets. To the extent that interbank loans are neither collateralized nor insured against, a bank's failure may trigger a chain of subsequent failures and therefore force the central bank to intervene to nip the contagion process in the bud. Indeed, it is widely believed by banking experts (and by interbank markets!) that industrialized countries adhere to a “too-big-to-fail” (TBTF) policy of protecting uninsured depositors of large insolvent banks, whose failure could propagate through the financial system, although authorities (rationally) refuse to corroborate this belief and like to refer to a policy of “constructive ambiguity” when discussing their willingness to intervene.2 Interbank transactions also reduce the transparency of a bank's

1 Trade credit has some specificities relative to, say, interbank lending. In particular,
the value of collateral (the wares in trade credit) is usually much larger for the creditor
(the supplier) than for other parties. Kiyotaki and Moore (1995) develop an interesting
model of decentralized trade credit and study propagation in a chain of supplier-buyer
relationships. The mechanics of their model (which is not based on peer monitoring)
are different from those presented here. Also, Kiyotaki and Moore focus on propagation
while, from our interbank lending slant, we are particularly concerned with the impact
of interbank lending on solvency and liquidity ratios and on the compatibility between
decentralized trading and centralized prudential control, and with the too-big-to-fail
policy.

2While this work emphasizes contagion in the banking system through interbank
transactions, financial distress may alternatively propagate through an informational

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