Risk Sharing and Interbank Market Fragilities

Abstract

Risk sharing among banks helps them diversify idiosyncratic risks, but their interbank borrowing costs can become more volatile and bring financial fragility. Banks facing liquidity shortages need to pay an extra cost of credit when their lenders have bargaining powers, which depends on the likelihood of fire-sale and the fire-sale price discount. Risk sharing can decrease likelihood of liquidity shortage and lower the borrowing cost. However, the fire-sale discount increases, since joint distress arises and more assets are liquidated simultaneously. Though the interbank borrowing cost decreases with risk sharing, it may become more sensitive to changes in aggregate uncertainty.