Monetary Policy and Cross-Border Interbank Market Fragmentation: Lessons from the Crisis
We present a two-country model featuring risky lending and cross-border interbank market frictions.
Financial system
A sound financial system is the bedrock of a strong economy. To help preserve financial stability, we study how links between financial institutions can generate system-wide stress and amplify economic downturns as well as issues about efficiency.
Participants in the financial system are highly interconnected. This means that the very links that make the system so efficient in normal times can spread and amplify instability during periods of stress. And while regulations can strengthen stability, excessively strict measures may limit the flow of funds to productive activities.
Ultimately, our research and analysis help find the right balance between stability and efficiency. This research is crucial for ensuring that financial vulnerabilities do not severely impact economic growth and employment.
Example of the issues we are exploring:
- how stress in one area of the financial system can spread to other areas
- the types of new tools needed to effectively assess systemic risk
- the effects on financial stability from a more competitive banking sector in Canada
- the impact of tighter regulations on operational efficiency in the financial sector
- how macroprudential policies affect household spending and investment decisions, as well as risks in the financial system
Systemic risk
Systemic risk is when a shock or a failure in one part of the financial system rapidly spreads to other parts of the financial system and is amplified, leading to a cascade of failures that threaten the entire system. Such risk can arise from various sources and primarily spread through the extensive links between financial institutions. We still have much to learn about where and how systemic risk could occur in Canada. For example, we must identify potential sources of risks, fully document and model links and understand how domestic and foreign financial markets may contribute to system-wide instability. The insights gained from this work strengthen our continued monitoring of the financial system and our collaboration with agencies that regulate the financial sector.
Stability and efficiency trade-offs
The global financial crisis of 2008–09 showed how inadequate financial regulations can contribute to system-wide instability. Since then, regulators across the world have tightened rules so the financial system is better able to absorb shocks and support economic activity during periods of stress. However, regulations that are too stringent can reduce the efficiency of the financial system in allocating funds, which hinders economic growth. Our research seeks to further our understanding of the fine line between promoting greater stability and preventing a loss of efficiency, particularly within the banking system.
Links between the real economy and financial system
The real economy and the financial system are closely related. A severe economic downturn may erode the financial health of lenders as some households and businesses default on loans. Conversely, an unstable financial system can trigger a credit crunch by restricting lending, which can lead to an economic downturn. Our research aims to further our understanding of these links by examining how the financial decisions of households and businesses affect the system and how financial shocks or macroprudential policies impact production and employment.
Related research
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Disclaimer
Bank of Canada staff produce research and analysis to support the work of the Bank and to advance knowledge in the fields of economics and finance. The research is non-partisan and evidence based. All research is produced independently from the Bank’s Governing Council. The views expressed in each paper or article are solely those of the authors and may differ from official Bank of Canada views.