Study On Mechanisms Of Interbank Market Affecting Financial Stability

The Great Recession during 2007 to 2009 began with the subprime mortgage lender faced a system wide default on real-estate mortgage, while the contagion of crisis in financial system may be attributed to liquidity dried up at the interbank market. The basic function of the interbank market is smoothing liquidity between banks, while liquidity dried up severely impaired this function’s work. Furthermore, shadow baking institutions badly hurt by the liquidity dried up were forced to liquidate assets, thus resulting in financial assets’ fire-sale. As a result, negative externalitie due to slumping asset prices together with mark-to-market accounting standard make banks and other financial institutions go into bankruptcy. After recover from this crisis, academics began to study the role of the interbank market during the crisis and advocated regulatory measures to help prevent such crisis from happening again. Despite the relatively small impact of crisis to Chinese economy, the pro and con of the U.S. experience is worth studying and pondering.In this paper, we are exploring the overall intrinsic mechanisms of interbank market affecting financial stability. Concretely, we focus on three major mechanisms: risk sharing, market discipline and risk of contagion. When faced with the financial system shock, risk-sharing mechanism can maintaining financial stability, while the market discipline and risk of contagion can amplify the consequences of financial shock and hinder the financial stability.The rest of our study is constructed as follow: Firstly, we survey the literature to understand the logic of the three mechanisms and in particular focus on empirical evidence based on Chinses background. Then we exploit a natural experiment to empirically test risk-sharing mechanism. Furthermore, based on panel data of China’s banks, we use instrumental variable estimator and find evidence of market discipline. Finanally, we find that "money shortage" incident is a good evidence of risk of contagion.