Publication - The role of counterparty risk and asymmetric information in the interbank market, by Giuseppe Cappelletti, Giovanni Guazzarotti
Interbank markets are crucial to banksí liquidity management and to the transmission of monetary policy. They represent an important funding channel, and their functioning a§ects borrowing conditions for households and Örms. The recent Önancial crisis had a severe impact on the European money market, driving up interest rates and drastically reducing total transactions.
A key feature of the crisis was the di¢ culty that the interbank market had in redistributing liquidity (see, for example, Brunnermeier, 2009). One of the causes of this relative market failure was liquidity hoarding, as banks stopped lending due to precautionary motives, given the illiquidity of their assets (Allen, Carletti and Gale, 2009). A second channel of contagion was the increase in actual and perceived counterparty risk, especially in the segments more exposed to information asymmetry, namely unsecured and cross-border positions (Heider et al. 2009). While most studies of the crisis following the Lehman Brothers bankruptcy have examined its overall e§ects on the interbank market, we focus speciÖcally on the impact of heightened of counterparty risk due to the sovereign debt crisis.
In 2010-11, when the crisis started, Önancial intermediaries in Greece, Portugal and, to a lesser extent, Spain and Italy had trouble raising wholesale funding and had to rely on central bank liquidity (Panetta et al. 2011). The increase in sovereign risk worsened banksí credit risk through several channels. First, losses on holdings of government debt weakened balance sheets, as banks are typically highly exposed to the debt of their own sovereigns. Second, higher sovereign risk reduced the value of collateral at banksídisposal in respect of wholesale funding and central bank liquidity. Third, sovereign downgrades generally resulted in lower ratings for domestic banks, increasing their wholesale funding costs and potentially impairing their market access. Fourth, the deterioration in sovereign Önancial sustainability reduced the funding beneÖts that banks derive from implicit and explicit government guarantees.
In July 2011 the spread between Italian and German ten-year government bonds jumped by 100 basis points and kept increasing through the end of the year, to over 4 percentage points. Adopting a quasi-experimental methodology, we exploit the sharp, sudden rise in the yields on Italian sovereign debt, which can be deemed an exogenous increase in the riskiness of Italian banks: both low growth and high public debt are in fact long-standing features of the Italian economy, and the interbank market was not a direct source of instability for public debt.
This paper seeks to gauge the extent to which the increase in counterparty risk due to the sovereign crisis a§ected Italian banksí access to foreign bank lending. We study the unsecured segment of the market and restrict analysis to foreign lenders, who may have less precise credit information on Italian borrowers than domestic banks and may be more sensitive to changes in credit risk. The focus on foreign lenders also helps to disentangle counterparty risk from the liquidity hoarding channel, since foreign banks were a§ected less severely by the crisis and had no motive for precautionary liquidity hoarding.
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