The Interbank Money Market and Contagion Risk
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Publication date: 2013-06-30
GNPJE 2013;264(5-6):19-41
The article analyzes the role of the interbank money market during financial crises. The research method used by the author includes a critical review of theoretical literature and empirical studies. Recently various publications have suggested that the failure of some institutions may have been brought about by banks and their excessive reliance on wholesale funds, the author says. Well-functioning interbank markets effectively channel liquidity from institutions with a surplus of funds to those in need, allowing for more efficient financial intermediation. Financial institutions worldwide have increasingly relied on wholesale funding to supplement demand deposits as a source of funds, thus becoming vulnerable to a sudden dry-up of these sources of funds. The reliance of financial institutions worldwide on short-term wholesale funds is among the possible sources of financial linkages, in addition to common portfolio investors and herding. For many years, the unsecured interbank market has been considered the archetype of an efficient market. Nevertheless, during the latest financial crisis, many of the certainties concerning interbank markets suddenly disappeared. The article reviews the most significant literature on some externalities and their effect on money market malfunctioning. One of the many striking features of the 2007-2009 crisis was a sudden freeze in the market for the rollover of short-term debt due to changes in investor behavior. The common aspects of investor behavior across crisis episodes indicate that they involved Knightian uncertainty (i.e., immeasurable risk) and not merely an increase in risk exposure, the author says. He adds that uncertainties in the financial system were transmitted to the real economy after the collapse of Lehman Brothers as expectations of future credit tightening, higher precautionary savings and the postponement of investment took a sudden and widespread toll on global demand.
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