Relationships in the Interbank Market

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In the interbank market for overnight loans, banks sometimes trade below the central bank's deposit rate. This act is puzzling, as it seems to miss exploiting opportunities for arbitrage. In particular, why do banks lend to other banks, exposing themselves to counterparty risk, when they could earn a higher rate by depositing the balances at a risk-free central bank?

This paper provides a theory to explain this anomaly. In the presence of market frictions, banks are motivated to build long-term relationships with each other to save the costs of searching for new partners every day. In this setting, lenders may sometimes cut the lending rate in the short run to keep their long-term relationship going. This relationship premium helps explain why some banks trade below the central bank's deposit rate, especially when they have a lot of liquidity.

The model also helps us understand how monetary policy affects the network structure of the interbank market and the way this market functions. In a recently published updated version of this paper, we use a calibrated version of the model to study interbank trades in the Euro area.