From crunch to crisis in the interbank lending market

This article examines the conditions under which a credit crunch becomes a credit crisis by studying one aspect of the current financial crisis: the month-long turmoil in the interbank loan market. The credit crunch began in 2007 but became a crisis when the bankruptcy of Lehman Brothers on September 15, 2008 created a systemic confidence shock. The resulting panic ended with the U.S. Treasury Department‟s bank recapitalization on October 14, 2008. We show that the crisis and the subsequent transformation of the interbank loan market can be explained as a prisoner‟s dilemma in which banks with excess reserves play a game of „loan or no loan‟ with each other. The initial game simulates the confidence shock and results in a Nash equilibrium where banks choose „no loan‟ and are made worse off. The second game incorporates governmental efforts to transform the market through the U.S. Treasury‟s recapitalization program and FASB changes in mark-to-market and risk-based asset pricing. Both current data and historical evidence from the Panic of 1907 indicate that such programs can work to solve asymmetric information problems and revive lending in the interbank loan market.