Interbank markets are the mean for the liquidity management and the transmission of monetary policy. Actually they work as the markets that banks use, to trade among themselves in order to remain liquid and meet their liabilities. Interbank markets function with two ways within the financial system. Firstly they can be used from the central banks as their median to intervene and enforce their policies so to configure the desired interest rates. Secondly, a well organized interbank market enable the financial system to effectively circulate liquidity by transferring funds from financial institutions that face surplus to those that are in need of liquidity (Furfine, 2001).Therefore, policy makers are in deep concern about any malfunction in the interbank markets, even more in the case of a liquidity crisis within the interbank markets. Their worries refer in particular in the patterns followed from the interbank interest rate, as the performance of the later represent the marginal cost of funding among banks. In the case that interbank interest rates rise, banks will face a higher funding risk and their only response will be higher liquidity hoarding. Banks will prefer to hold more reserves, being reluctant to any potentially risky investment through interbank lending to other institutions that will possibly be affected by an ongoing financial instability. This fact will coincide to the failure of the interbank market to function successfully by allocating funds within the financial system and will conclude to an interbank market liquidity crisis.
In addition to these effects an increase in counterparty risk and asymmetric information will cause an adverse selection problem in the interbank market, resulting in even more higher level of liquidity hoarding and in a severe impairment of the market possibly concluded in its total break-down (Heider et. al. 2009).
This view comes in line with Flannery (1996), who observed that even if policy makers are well informed interbank markets can fail. The reason is that, during a crisis it is neither clear to the market participants, nor to the central bank how to distinguish an insolvent from an illiquid bank. As a result its creditworthiness is doubtful. Implicit in this the lending bank itself is unsecure about the creditworthiness of its counterparties (counterparty risk) so is unable to diversify its interbank lending portfolio across other assumed illiquid banks resulting in refraining from interbank lending and thus provoking liquidity crisis.
Interbank activities among financial institutions will be limited and financial intermediation will collapse. This inability of banks to obtain the funds needed to maintain their business, failing to remain liquid and meet theirs depositors’ demands for withdraws and borrowing will generate a credit crunch with implications for the general economic stability.
Interbank credit lines allow institutions to cope with liquidity problems while reduce the cost of maintaining reserves. At the same time though, they expose the financial system to the risk of coordination failure even if all the banks that participate are solvent. The systemic risk that arises throughout the interbank transactions is capable of generating a chain reaction to the whole economic system triggered by the default of only one bank.
Meanwhile, Freixas et al (2000) went further to the reasons that cause liquidity crisis, pointed out that liquidity needs that set in function the interbank markets are generated from the uncertainty the consumers have, in where they want to consume. So in case that the depositors of one location wish to consume in another location and think that there will not be enough resources in that destination then their best response will be to withdraw deposits at their home location. This fact will trigger the early liquidation of the investment in the home location witch with backward induction will make it optimal for the depositors to other location, imitating the behavior of the formers. The consequences of this series of actions will be once more, the malfunction of the interbank market in a way that a small liquidity shock in one location may spread to the rest of the economy.
It can be reasonably argued given the recent literature that interbank markets played a major role in the last liquidity crisis. The financial markets turmoil in the summer of 2007 caused by a severe subprime crisis in the U.S housing market set the alarm for the experts to re-appraise the phenomenon of "financial crisis", as the liquidity problems that were provoked into the economic system were profound have never been met in the past. The events that led to the credit crunch of 2007 might have started from the housing markets but the combination of trade frictions, expected liquidity shortage and increase in the credit risk, was that triggered the most prolonged depression of all times. A series of events increased the funding risk of banks which with their turn responded with higher liquidity hoarding that resulted in even higher interest rates.
The majority of interbank activities are conducting through overnight unsecured lending where there is no need for collateral and since this is the safest option for a lender to solve its liquidity problems. Thus, overnight rates are very sensitive to illiquid situations and any problem in the interbank market is being reflected firstly in them and afterwards to the rest of the markets. In the case of the crisis of 2007 such effects were witnessed with severe increases on overnight bank rated lending activities for both secured and unsecured markets (Acharya et al 2009)
The event of the crisis of 2007 in asset backed securities  within the housing markets, affected the money markets and the interbank market as well. Market participants pursued to higher yields and turned into more risky and high leveraged investments as a consequence of a prolonged "peaceful" period characterized by financial stability with consistent and low interest rates since 2003. These reactions increased the market liquidity and encouraged investors to take positions in even more risky assets as the increasing liquidity reduced the interest rates volatility.
Meanwhile, commercial banks have already adopted the model of the "originate and distribute" providing the money market with a whole new range of assets. The idea of the model "originate and distribute", was to securitize and sell the loans on the financial markets allowing in this way the banks that initially granted the loans to diversify part of the risk by transferring it to the counterparties and gain back liquidity for further lending.
Normally banks create separate entities the so called "structured investment vehicles" (SIV) which are dependent on the banks that originate them but do not appear on their balance sheet. These tools are responsible for the diversification of the risk as it spread among other parties contributing in this way to the financial stability. Nevertheless these functions require an effectively and correct asset pricing system along with accurate risk assessment and proper management. Always under the assumption, that the procedure of securitization does not change the incentives for ex ante screening and ex post monitoring.
Unfortunately in the case of the crisis of 2007 none of the above mentioned assumptions obtained
Uncertainty concerning the condition of the structural investment vehicles,
which relied on the assets-based paper markets as the source of finance, forced
the banks to consider possible support of their subsidiaries. Since the exact
magnitude of the losses was initially unknown, the banks assumed the worst
and acted as if they were facing an impending out of low of liquidity.
Such behaviour constitutes a deviation from the rational expectations hypothesis
since it is impossible for all the banks to become short of liquidity when
aggregate liquidity does not change. (Kempa 2009)
In that case of the suspended withdrawals from some of its hedge funds invested in sub-prime mortgagebacked securities due to the inability to mark these assets to market. The result was a freeze in the market for asset-backed commercial paper (ABCP), which caused rollover problems for structured investment vehicles (SIV’s) and conduits set up by banks as off balance sheet vehicles for liquidity and regulatory arbitrage purposes. As the ABCP liquidity dried up, banks took assets from SIV’s and conduits back on their balance sheets. The resulting uncertainty about the extent of such assets that banks would have to take back on balance sheets, the magnitude of losses banks faced, and whether they had enough capital to bear these losses affected not just capital markets but also the inter-bank market for borrowing and lending activities.
The average interbank market interest rate which is the tool of operational policy, increased especially for the longer maturities along with the increase in rates’ volatility. There was when liquidity hoarding came into the spotlight when banks in their attempt to satisfy their reserves requirements started to hold cash beyond the necessary level, a fact that blocked the efficient allocation of liquidity among banks. This precautionary hoarding by some settlement banks raised lending rates for all settlement banks, following a chain result triggered of contagion style systemic risk. Thus, volatility in overnight interbank rates affected immediately rates in commercial banks having effects to the rest of the financial system.
As pointed in Acharya et al (2009) the subprime crisis of 2007 was partly triggered from the liquidity crisis of the interbank market which in its turn was a result of precautionary hoarding of liquidity from the financial institutions due to their insecurity about their ability to lend or to be lent in the future. According to sources from the Bank of International Investments (BIS) only in the United Kingdom liquidity hoarding increased 30% in the period right after the 9th of August of 2007.
Brunneti et al (2009) suggested that the sub-prime crisis has created serious liquidity issues for the interbank market. Banks, unsure about the depth of the problems on other banks’ balance sheets, have simply not been willing to lend to each other without substantial accommodations for counterparty risks. To counteract the resulting lack of liquidity in the interbank market, central banks have been proactive in injecting liquidity into the system.
Regarding the channel through which the liquidity crisis affected the interbank markets, the European Central Bank (E.C.B 2007) official statement is that: "The squeeze in the interbank money market reflected the fact that participants in the market became fearful about counter party credit risks and they also hoarded liquidity in case of unexpected need”.
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