Knightian uncertainty and interbank lending

This paper theoretically studies the effects of Knightian Uncertainty in interbank markets when the source of the Knightian Uncertainty is incomplete information on banks’ risk exposures. The main findings in the paper are: (1) When interbank loans are arranged in anonymous brokered, instead of bilateral markets, it attenuates the effects of Knightian Uncertainty on their interbank spreads and (2) Knightian uncertainty severely constrains small banks’ ability to borrow in anonymous brokered interbank markets. The findings help explain why there was an increase in the relative use of interbank brokered markets in Euro-currency countries that occurred between the second quarter of 2007 and the second quarter of 2008. The findings are also consistent with constraints on small banks’ ability to borrow in brokered interbank markets in the US.