Paper #579

Title:

Interbank market integration under asymmetric information

Authors:

Xavier Freixas and Cornelia Holthausen

Date:

March 2001

Abstract:

We argue that the main barrier to an integrated international interbank market is the existence of asymmetric information between different countries, which may prevail in spite of monetary integration or successful currency pegging. In order to address this issue, we study the scope for international interbank market integration with unsecured lending when cross-country information is noisy. We find not only that an equilibrium with integrated markets need not always exist, but also that when it does, the integrated equilibrium may coexist with one of interbank market segmentation. Therefore, market deregulation, per se, does not guarantee the emergence of an integrated interbank market. The effect of a repo market which, a priori, was supposed to improve efficiency happens to be more complex: it reduces interest rate spreads and improves upon the segmentation equilibrium, but\ it may destroy the unsecured integrated equilibrium, since the repo market will attract the best borrowers. The introduction of other transnational institutional arrangements, such as multinational banking, correspondent banking and the existence of "too-big-to-fail" banks may reduce cross country interest spreads and provide more insurance against country wide liquidity shocks. Still, multinational banking, as the introduction of repos, may threaten the integrated interbank market equilibrium.

Keywords:

Banking theory, asymmetric information, financial integration, interbank markets, diamond-dybvig

JEL codes:

G15, G20, F36

Area of Research:

Finance and Accounting

Published in:

Review of Financial Studies, 18(2):459-490, 2005

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