SUNANDO ROY – On Banking, Finance and Society

Published by sunandoroy on Thu, 2007-03-29 10:53

The interbank market is not an isolated market, it is linked to other segments of the financial sector and macroeconomy. Macroeconomic shocks through their influences on liquidity and asset prices influence the interbank market and change its risk profile. Second, opening up of the external sector may lead to growing cross-border interbank exposures and can increase risks in interbank markets. The level of internationalisation of the interbank market heightens the risks of interbank exposure. Exceptionally high proportions of cross-border interbank loans and deposits highlight a feature of the interbank market in developed countries which potentially transforms the risk of contagion, as well as the way it should be handled. Given that the lion’s share of the inter¬bank exposures are situated abroad in advanced countries, banks are more sensitive to international crises than to domestic ones, and any attempt to assess the impact of interbank markets on financial stability must be viewed in that perspective. India is fast integrating with the global economy, and the lessons from the global economy may be instructive.
Mergers reduce risks in Interbank markets
The cross country literature reveals that the interbank market risk reduces when mergers and consolidation takes place. The world over, mergers are taking place in the banking sector at a rapid pace. This is likely to reduce the risk profile of interbank markets.

Tax Policy
Government tax policies in domestic markets often lead to flow of funds towards international interbank markets, with heightened credit and liquidity risks.

Maturity Profile
Maturity structure of inter-bank liabilities bears a close relation to risk. If interbank loans and deposits show a relatively short maturity, banks use interbank markets mainly to manage their short-term liquidity needs, so the risks are limited.

Institutional Mechanisms towards Risk Mitigation

Internationally, several institutional mechanisms were found to be useful in reducing the risks in interbank market.
First, the existence of collateralized interbank market (a well developed and liquid repo market) reduces the risks of contagion. However, the existence of a repo market may lead to the disappearance of the uninsured international interbank market (Freixas and Holthausen, 2001). This can occur as a result of asymmetric information; a bank that attempts to obtain an unsecured cross-border loan may be suspected of having had the loan denied by other domestic banks which have more information about the borrower.
Second, the use of netting contracts among banks is a mechanism for reducing interbank exposures. A problem at one bank is then less likely to initiate a “domino effect” on the interbank market. Emmons (1995), however, shows that netting of interbank claims shifts the bank default risk away from interbank claimants towards non-bank creditors, i.e. the risk is transferred to the banks’ creditors who are not included in the netting agreement.

Role of Central Banks
The Central bank has a major role to play in reducing the risks in interbank market. Potential central bank intervention, as well as the presence of safety nets, lowers contagion risk in the interbank markets . There are several forms of central bank intervention to contain interbank exposure risks. They are :

(i) Liquidity Management
Central banks may decide to provide liquidity to the market as a whole when aggregate liquidity is insufficient, or directly to individual banks when the market fails to provide liquidity to sound financial institutions. Moreover, although interbank exposures are not explicitly covered by deposit insurance, issues such as “too-big-to-fail” may introduce implicit deposit insurance for these exposures.

(ii) Containing Market Expectations
Central Banks also play a crucial role in arresting “Spill-overs” of market expectations. Regulatory intervention such as suspension of convertibility or deposit insurance or even active communications policy may alleviate the problem of bank runs and banking panics (Freixas and Rochet, 1997).

(iii) Limits to large counterparty exposures:
Limits imposed by authorities on banks’ large exposures and proper monitoring and control of large exposures of credit institutions contribute to reducing contagion risk. Limits are usually formulated in terms of banks’ own funds.

(iv) Challenges to Banking Supervision
A regulator entrusted with the mandate of financial stability needs to differentiate between fundamental instability and systemic instability. Banks may default as a direct consequence of shocks (fundamental insolvencies), but also due to a chain reaction, i.e. because other banks defaulted in the first place. The latter cases may be regarded as insolvencies caused by chain reactions (contagious insolvencies). It may be noted that Banking supervision, which focuses on the individual institutions, has no in-built mechanism to arrest systemic insolvencies and thus inadequate to detect such risks. In this context, the need for a separate mechanism to monitor the systemic risks emanating from interbank markets can hardly be underscored. (v) Effective use of data on Interbank Exposures
Also relevant is to devise a mechanism for optimal use of interbank data, including creation of database, regular monitoring, relevant reporting and assessment of risks. Periodic stress testing by the central banks may be necessary in this regard. In this context, it may be useful to further explore application of a network model in the Indian context by using advanced matrix analysis and entropy optimization.