Information, liquidity and risk in the international interbank market: implicit guarantees and private credit market failure

Working Papers No 86
March 2000
This paper considers the functioning of the international interbank market (IIBM), its contribution to the recent financial turbulence in Asia, and the policy issues presented by the existence of moral hazard and implicit guarantees of interbank liabilities. The paper provides statistical analysis to document the existence of contagion in the interbank market. While previous researchers had cautioned of the possibility of contagion in the IIBM, statistical support for its existence was relatively sparse. Within geographic regions, interbank market contagion appears much more prevalent within Asia than within Latin America. Between regions, the contagion appears to have been from Asia to Latin America. The paper discusses the possible role of implicit government guarantees of international interbank credit in contributing to inflows into emerging market countries, where significant information asymmetries made difficult the analysis of counterpart risk. It is argued that because of the serious informational problems in some segments of the international interbank system, the market is subject to potential disruption. The implicit guarantees given to risky borrowers in the IIBM can be thought of as a subsidy which helps to ensure the viability of the market. In principle, it is similar to a subsidy that is provided a market with extreme adverse selection problems. It can, however, also be a source of instability if not properly managed.