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| Financial Contagion, Market Freezes, and Prudential Policies in the Interbank Market—A Network Perspective |
| FAN Zhongjie, HE Ping, LIU Zehao
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China School of Banking and Finance, University of International Business and Economics;
School of Economics and Management, Tsinghua University;
School of Finance, Renmin University of China |
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Abstract As one of the most important components of the financial market, interbank market stability is crucial to maintaining stability throughout the financial system and guarding against systemic risks. Sudden freezes in the interbank market are precipitous declines or near-stagnation in transactional activity. Such freezes pose a significant threat to market stability, as demonstrated by historical financial events. In 2007, the subprime debt problem affecting some United States banks expanded to affect the whole market through the interbank lending network; consequently, the interbank market transaction scale shrank significantly, and interbank lending with a slightly longer maturity period almost disappeared, a typical sudden freeze phenomenon. The liquidity problem caused by this sudden freeze of the interbank market led to a rapid amplification of the financial crisis and, eventually, a serious negative impact on the whole financial system.
This paper establishes a financial network model to explicate the phenomenon of a sudden freeze in the interbank market through the lens of risk contagion. Within this network model, banks engage in mutual borrowing, with each bank facing independent liquidity shocks that may propagate throughout the banking system. Within the intricate structure of the lending network, banks internally negotiate and determine lending contracts. Our analysis reveals that risk contagion gives rise to multiple equilibria in the magnitude of bank lending. Notably, when the liquidity risk exceeds a threshold, the volume of transactions in the interbank market can decline suddenly and precipitously in response to a shift in the lending equilibrium. This finding offers a plausible explanation for the market freezes that occur during financial crises.
To effectively intervene in interbank market freezes, prudential authorities can actively adjust collateral and cash in the market through open market operations. Collateral plays a pivotal role in mitigating bankruptcy risk contagion. Replacing cash with collateral of equivalent value enhances banks' risk resilience, thus increasing the scale of interbank lending when the liquidity risk is high. However, the reduction in cash lowers the maximum amount of financing available, thereby constraining banks' borrowing capacity when the liquidity risk is low. Consequently, the optimal balance of collateral and cash is a crucial aspect of policy intervention in the interbank market. Prudential authorities should assess this balance and compare it with banks' initial endowments to decide whether to adopt collateral injection or liquidity injection policies as part of their intervention strategy.
Regulatory policies such as liquidity supervision and window guidance policies can also prevent interbank market freezes. Under liquidity supervision, banks must increase their proportion of cash. In a high lending equilibrium, banks spontaneously hold a low proportion of cash, increasing their susceptibility to regulatory constraints. Comparatively, in a low lending equilibrium, banks spontaneously hold a high proportion of cash and are thus less affected by such constraints. Thus, liquidity supervision causes banks to spontaneously choose the low lending equilibrium and focus increasingly on preventing risk contagion. Similarly, window guidance policies support market equilibrium transitions; they help avoid disruptive equilibrium jumps and hard landings in the market by moderating banks' investment return and contagion prevention incentives.
The main contributions of this paper are as follows. First, it introduces a novel mechanism underlying interbank market freezes, which is grounded in a financial network model. Building upon the established network framework, this paper internalizes the lending contract. Our analysis reveals that a contagious risk gives rise to multiple equilibria in the interbank market, where negative shocks can trigger abrupt shifts in lending equilibria and unexpected changes in market size. This theoretical framework offers an explanation for the sudden emergence of financial crises. Second, this paper provides crucial insights into risk prevention and mitigation policies by examining the impact of a contagious risk on banks' lending decisions. Specifically, it highlights the importance of the injection of collateral into the market by the central bank during times of heightened risk. Additionally, this paper revisits liquidity regulation and window guidance policies from the perspective of interbank lending equilibria. These insights offer a rich array of policy options for preventing and mitigating unexpected freezes in the interbank market.
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Received: 18 November 2022
Published: 17 July 2024
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