Banks Borrowing Costs and Default Risk < Back
I explain the increase in unsecured borrowing costs in the interbank market during the recent financial crisis using a model with endogenous default, in which banks with different default risk borrow at different interest rates. I compare a normal times stationary equilibrium and a crisis times stationary equilibrium. In normal times there is no spread in the interbank market, because the default probability of banks is zero. In crisis times some banks default, and an interbank credit spread arises endogenously. The interbank credit spread is positively correlated with leverage and debt size, and negatively correlated with expected cash flows. Using this framework, I study the effects of equity injections, debt guarantees, and liquidity injections on the interbank credit spreads. I find that debt guarantees are effective in decreasing banks' borrowing costs in times of crisis. In contrast, borrowing costs are relatively unresponsive to injections of equity and of liquidity.
Speaker: Jonas Arias, Duke University
Coordinator: Prof. Morten Olsen