Allen and Gale (2000), extended the original model of Bhattacharya and Gale (1987), to show two different structures of interbank markets: one is the interbank market with credit chains (incomplete market), where a bank has a connection only with its neighbour; and the other is the interbank market with diversified lending (complete market), where a bank has symmetric links with all others. Lower risk-taking is indicated in the complete market, where the risk of interbank lending can be shared by more than one lending bank. Considering the role of the central bank in the context of the interbank market, Freixas et al. (2000), based on the original model of Freixas et al. (1998), present a disconnected multiple money centres market structure (Figure 3-2), where borrowing banks have a connection with the money centre banks (A and E). The risk level of interbank trading depends on the position of the failed bank. The bankruptcy of the money centre bank leads to serious consequences for the financial system, since it is connected with other banks, large non-financial firms and even the government. This theoretical model highlights the role of the Central Bank (CB) and indicates that the optimal strategy of the CB is to provide additional protection for money centre banks in order to minimise the costs of intervention under TBTF. As shown in Figure 3-2, the CB, as the lender of last resort (LLR), would lend to a money centre bank having an illiquidity problem. In addition, the structure of the interbank market in many countries, such as Germany, Belgium and Austria, is characterised as a multiple money centre banks market (Figure 3-3), where the money centre banks have a connection between each other. Compared with the structure shown in Figure 3-2, the risk level is higher in the structure shown in Figure 3-3, where money centre banks are connected and the contagion effect in turn can be spread to other money centre banks that are linked together. To some extent, the implication of the
73 multiple money centre bank market structure is consistent with the policy of TBTF, that they are protected by CB and hence might be associated with a higher level of risk-taking owing to moral hazard.
Rochet, 2000)
Figure 3 Interconnected Money Centre Bank Market Structure (Freixas, Parigiand Rochet, Bank B Bank A Bank D Bank C Bank E BankH BankG Bank F CB Bank B Bank A Bank D Bank C Bank E Bank H Bank G Bank F CB Figure 3.6
Figure 3-2 Disconnected Multiple Money Centre Bank Market Structure (Freixas, Parigi and Rochet, 2000)
Figure 3-3 Interconnected Multiple Money Centre Bank Market Structure (Freixas, Parigi and Rochet, 2000)
According to the introduction to market structure and TBTF above, we may argue that under the development of interbank market structure, the money centre bank market structure highlights the important role of CB in maintaining a stable financial system. Given a multiple money centre bank market structure, CB is willing to rescue big banks that are in key positions of the economy considering TBTF, which may increase the incentives of big banks to be involved in risky activities, suggesting different risk levels in terms of large and small banks.
The existing empirical modelling has concentrated on the effect of the interbank market structure on risk-taking using matrix analyses28. In these studies, balance sheet data or large interbank exposures data are used as a proxy to determine the structure of interbank markets. Upper and Worms (2002) estimated the Germany interbank market by applying 25 matrices of bilateral exposures in terms of maturity and bank categories (saving banks, cooperative banks, commercial banks, Landesbanken and the cooperative central bank). They find that the German interbank market is two-tier: in the upper tier, the structure of interbank exposures is close to a complete interbank market structure (for savings banks and cooperative banks), while in the lower tier, the interbank market is associated with an incomplete structure (for commercial banks, Landesbanken and the cooperative central bank) and suggest that the contagion risk is lower in a complete market structure than in an incomplete market structure. Wells (2004) suggests that in the UK, large banks engage in operations between each other and the small banks borrow credits from large banks, which is consistent with the implications of the multiple money centre bank structure as suggested by Freixas et al. (2000). However,
28 Basically, the idea of matrix analyses is that
j i
x, is credit exposure of bank j VS bank i (bilateral exposures), if the product of xi,jand the loss rate is bigger than the book value of bank i, suggesting that bank j trigger the failure of bank i.
75 Cocco et al. (2009) suggest that a different structure exists in the Portuguese interbank market, where large banks tend to be net borrowers as they have more opportunities to invest; while small banks specialise in deposit-taking but have few investments, so they having sufficient liquidity can lend to large banks. Degryse and Nguyen (2004) analyse the contagion effect using Belgian banks from 1993 to 2002. They stress the importance of interbank market structure in determining contagion risk. A change in market structure from a complete market to a multiple money centres market allows contagion risk to be reduced, since in some cases, the failure of borrowing banks (small banks) linked to a money centre bank cannot lead to the failure of the money centre bank protected by CB, which is consistent with the implications of the framework suggested by Freixas et al. (2000).