The Real Effects of Endogenous Defaults on the Interbank Market
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The Real Effects of Endogenous Defaults on the Interbank Market Massimo Minesso Ferrari1,2 Received: 13 February 2019 / Accepted: 15 July 2019 © Società Italiana degli Economisti (Italian Economic Association) 2019
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). Keywords Macrofinance · Contagion · DSGE · Interbank Market · Heterogeneous Agents · Monetary Policy JEL Classification E44 · E32 · E52 · E58 · D85
The views expressed are those of the author and do not necessarily reflect those of the European Central Bank or its Executive Board. I am grateful to Domenico Delli Gatti, Gianluca Femminis, Alessandro Flamini, Giovanni Lombardo, Maria Sole Pagliari, Justine Pedrono, Patrizio Tirelli and participants at seminars at the Catholic University of Milan and the Bicocca University of Milan. Electronic supplementary material The online version of this article (https://doi.org/10.1007/s40797019-00104-0) contains supplementary material, which is available to authorized users.
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Massimo Minesso Ferrari [email protected]
1
European Central Bank, Frankfurt-am-Main, Germany
2
Catholic University of Milan, Milan, Italy
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M. Minesso Ferrari
1 Introduction After the default of Lehman Brothers, the US interbank market became illiquid, leading to a further tightening of the liquidity constraints faced by banks (already in distress).1 Large stimulus by central banks had limited effects as banks started to change the composition of their balance sheets using excess resources to purchase risk-less assets, crippling the transmission of monetary policy (see Fig. 1). This led to a collapse in interbank and final credit, investment and aggregate demand (Brunnermeier 2009; Angelini et al. 2011).2 A central role was played by financial agents’ expectations on the solvency of their counterparts with standard measures of risk, such as the VIX, spiking during the GFC, see De Socio (2013). This paper analyzes the role of counterparty risk on the interbank market for the portfolio choices of banks and how it affects the real side of the economy. In particular, the analysis is based on a ge
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