Interbank borrowing and lending between financially constrained banks (Q2205988)

The authors argue that lending to another bank can reduce a bank's overall portfolio risk through diversification. If insolvency is costly, this diversification improves the interbank lender's funding liquidity, boosting credit supply to nonbanks. However, diversification comes at an endogenous cost, that depends on bank-specific factors of interbank borrower and lender. Their model provides a framework for understanding the importance of interbank lending for aggregate credit supply and the stability of banking systems. The model's predictions are consistent with evidence documented in the literature that other theories cannot consistently explain.