Do interbank markets price systemic risk?

Abstract

The breakdown of the interbank market was a critical moment in the unfolding of the global financial crisis of 2007–2008. We argue that the adequate pricing of risks is critical for the functioning of a market of such vital importance as the interbank market. We use a unique panel data set that allows us to quantify counterparty risk and different types of systemic risks associated with interbank exposures. We use a simultaneous equation model for interbank lending and deposit rates to study whether counterparty risk and systemic risk are adequately priced. As expected, we find that riskier banks on average pay a higher deposit rate. However, on average, banks grant a discount in their lending rates to riskier banks. For systemic risk, we also find mixed results. The positive effect on the deposit rate declines, but the negative effect on the lending rate remains. We argue that the mixed results regarding the pricing of systemic risk might ex-post justify parts of the Basel III reform package that forces systemically important banks to hold higher capital buffers.