Counterparty Default Risk and Monetary Policy in Unsecured Interbank Lending Markets

Abstract

Banks bargain over the cost of unsecured loans in a model of interbank lending markets characterized by counterparty default risk. The risk an individual bank defaults depends on both idiosyncratic and aggregate factors and impacts loan rates and participation in the interbank loan market. After a deterioration of the aggregate factor affecting default risk, participation in interbank lending markets declines, and both individual and the average interbank loan rates rise. The model suggests that some policy actions enacted during the late-2000s financial crisis may have reduced participation and increased spreads in unsecured interbank loan markets.