Discipline and Liquidity in the Interbank Market


  • I thank Bill English, Steve Fazzari, Mark Flannery, Craig Furfine, Jon Garfinkle, Alton Gilbert, Greg Sierra, Rajeev Sooreea, Dan Thornton, Mark Vaughan, Tim Yeager, anonymous referees, and seminar participants at the Midwest Economics Association and Econometric Society meetings for helpful comments. Any remaining errors are mine alone. The opinions expressed herein do not reflect official positions of the Federal Reserve System.


Using 20 years of panel data, I demonstrate that high-risk banks have consistently paid more than safe banks for interbank loans and have been less likely to use these loans as a source of liquidity. The economic importance of this effect was relatively small until the mid-1990s, when regulatory and institutional changes began to impose more of the costs of bank failure on uninsured creditors. Subsequently, interbank-market price discipline roughly doubled, and risk-based rationing effects increased by a factor of six. In imposing this discipline, lenders seem to care most about credit risk at borrowing institutions.