Knightian uncertainty and interbank lending

Matthew Pritsker

No RPA 12-4, Supervisory Research and Analysis Working Papers from Federal Reserve Bank of Boston

Abstract: The bursting of the housing price bubble during 2007 and 2008 was accompanied by high interbank spreads, and a partial breakdown of interbank lending. This paper theoretically models how Knightian uncertainty over banks risk exposures may have contributed to the breakdown. The paper shows: 1) the two-tier structure of the U.S. Fed Funds market makes it robust to uncertainty, but the market may nevertheless collapse ? and private incentives to restart it may be insufficient. 2) In some circumstances government bank audits and information releases about exposures that resemble a stress test can restart markets and improve welfare by internalizing an externality associated with economy-wide uncertainty reduction. 3) Collapses due to uncertainty are less likely ex-ante and less costly to fix ex-post when there is better publicly available information on core banks aggregate risk exposures. Based on 2) and 3), ex-ante and ex-post ?transparency initiatives? are proposed. Their success depends on the financial architecture of bank interlinkages.

Keywords: Risk; Banks and banking; Interbank market; Federal funds market (United States) (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-ban and nep-cba
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
http://www.bostonfed.org/bankinfo/qau/wp/2012/qau1204.htm (text/html)
http://www.bostonfed.org/bankinfo/qau/wp/2012/qau1204.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedbqu:rpa12-4

Ordering information: This working paper can be ordered from

Access Statistics for this paper

More papers in Supervisory Research and Analysis Working Papers from Federal Reserve Bank of Boston Contact information at EDIRC.
Bibliographic data for series maintained by Catherine Spozio ().