Interbank Network Risk, Regulation, and Financial Crises.

• Author: Jaremski, Matthew S.

The financial crisis of 2008-09 intensified interest in how relationships within the financial system can amplify and transmit shocks. At a basic level, firms took advantage of rising real estate prices by scaling up lending and leverage, which fueled further increases in asset prices. When asset price growth slowed, problems at individual financial institutions suggested problems at other firms and triggered a reduced ability to borrow for many firms, whether or not they were contractually connected to the mortgage credit shock. For example, in September 2008, the inability of the Reserve Primary Fund to maintain a constant $1 per share price led to runs on other money market mutual funds, including many that had little or no direct exposure to Lehman Brothers or the Reserve Primary Fund. Moreover, as the interbank lending market collapsed, banks scrambled to hoard reserves as a means of self-insurance against prospective liquidity needs, further aggravating declines in asset prices and lending.

Despite the importance of modern financial markets, their complexity makes it hard to study the effects of asset price shocks or how they are transmitted and amplified across firms and markets. For instance, information about a bank's interconnections with other lenders--its "counter-party positions"--is often closely held and accessible to only a handful of researchers at regulatory agencies. Further, with many banks having international branches and engaged in a wide variety of off-balance-sheet activities, it is difficult to distinguish the effect of a single shock or policy from other concurrent factors.

My research uses the lens of history for insight into these dynamics. US financial history is advantageous for a variety of reasons. First, as most states prohibited or severely restricted interstate bank branching, the financial statements of individual banks reflect their lending to local customers. This creates a large sample of banks to study, each of which operates in a distinct economic environment. Moreover, historically, few banks engaged in significant off-balance-sheet activity. This structure facilitates the identification of the effects of shocks to individual banks from other simultaneous macroeconomic factors. Second, the financial statements of each bank were publicly available, and publications often listed each bank's specific interbank correspondent connections. The historical period, therefore, is the only time when a full picture of the nation's interbank network can be studied without confidential data. Third, there was a great deal of regulatory variation within the country's unified legal and monetary system. Each state had regulatory control over its state-chartered banks, while national banks chartered by the Comptroller of the Currency faced a common set of regulations throughout the country. This feature allows the study of banks that are in the same location and during the same year, but subject to different sets of regulations. As highlighted below, the historical environment sheds light not only on the factors that lead to financial panics, but also on how interbank dynamics play out during panics.

Commodity Shocks and Regulation

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