"Knightian Uncertainty and Interbank Lending"

Abstract:

The bursting of the housing price bubble during 2007 and 2008 was accompanied by high interbank spreads, and a partial breakdown of interbank lending. This paper models Knightian uncertainty over banks risk exposures and shows how it may have contributed to the breakdown. The paper shows: 1) the two-tier structure of the U.S. Fed Funds market make it robust to uncertainty, but the market may collapse - and private incentives to restart it may be insufficient. 2) In some circumstances govern- ment bank audits and information releases about exposures can restart markets and improve welfare by internalizing an externality associated with economy-wide uncer- tainty reduction. 3) Collapses due to uncertainty are less likely ex-ante and less costly to fix ex-post when there is better publicly available information on core banks aggre- gate risk exposures. Based on 2) and 3), ex-ante and ex-post "transparency initiatives" are proposed. Their success depends on the financial architecture of bank interlinkages. This suggests that public policies aimed at resuscitating markets through uncertainty reduction need to focus on both asset exposures and the architecture of financial in- terlinkages.