The Real Effects of Endogenous Defaults on the Interbank Market

Abstract

This paper explains the reaction of the interbank market to confidence shocks by means of a micro-founded general equilibrium model with heterogeneous banks. The contribution of the model is threefold: first, it micro-founds the decision problem of banks, by explicitly relating counterparty risk to the issuance of new credit on the interbank market and showing that this channel amplifies the effects of the shocks; second, the model analyses the effects of a pure confidence crisis (i.e. when banks assess that their counterparts on the interbank market are more likely to default despite the fundamentals remain sound) showing that its effects are long-lasting and severe (i.e. a 1% increase in risk generates a contracts GDP by 1.5 bp and investments by 50 bp); third, the model shows that conventional policies to offset a confidence crisis (i.e. monetary policy cannot restore trust on the interbank market and solve the liquidity crisis induced by a confidence shock induces).