Systemic instability of the interbank credit market: A contribution to a resilient financial system

This theoretical model analyzes the impact of interbank credit market dynamics on the resilience of the financial system. Based on a stochastic model of interbank market credit flows, lending in the interbank market is restricted by the availability of liquidity. Following a shock materialization, a sequential flow adjustment process sets in. While the market smoothly adjusts under normal conditions, the characteristics of the market adjustment process change under volatile conditions, resulting in a bifurcation of the equilibrium. Market resilience declines under higher volatility, including a potential market freeze. A change in the volatility of reserve flows, which is more likely when central banks tighten monetary policy, may threaten the resilience of interbank markets and increase the probability of the market to fall into a regime of unstable dynamics. Thus, we stress that monetary policy could incidentally reduce financial stability. When switching the regime, policymakers should be aware of a potential reduction in interbank credit market resilience and the consequences for financial stability.