Discipline and Liquidity in the Interbank Market

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. Copyright (c)2008 The Ohio State University.