Inefficiency of bilateral bargaining in interbank markets

Abstract

Many countries have interbank markets that are over the counter (OTC) instead of exchange mediated. In OTC systems, bilateral bargaining takes place over the rate of interest on the (interbank) loan. This article characterizes such bilateral bargaining for loans between banks under asymmetric information and shows that bargaining outcomes maybe inefficient. The article suggests two sources of inefficiency. In a one-period model, bargaining between two banks may fail due to incomplete information even if gains to trade exist. Intertemporal issues examined in this article reveal that repeated interaction could create distorting effects through reciprocal contracts. Both cases are shown to require active liquidity management by the regulatory authority to restore the first best allocation.