We introduce a structural dynamic network model of the unsecured interbank lending market. Banks are subject to random liquidity shocks and can engage in costly peer monitoring to reduce counterparty risk uncertainty and counterparty search to find potential trading partners for bilateral Nash bargaining. We estimate the structural parameters by indirect inference using network statistics of the Dutch interbank market from 2008 to 2011. The estimated model accurately explains the high sparsity and stability of the lending network. In particular, monitoring of counterparty risk and directed search are key factors in the formation of stable interbank lending relationships that are associated with improved credit conditions. Moreover, the estimated degree distribution is highly skewed with few very interconnected core banks and many peripheral banks that trade mainly with core banks. Shocks to credit risk uncertainty can lead to extended periods of low market activity, but reactions are heterogeneous across trading partners. Finally, our monetary policy analysis shows that a larger discount window leads to a more active market through a direct effect and an indirect multiplier effect by increasing banks’ monitoring and search efforts.

Discussant: Lucy Gornicka (University of Amsterdam)