Interbank financing and business cycle in Europe

Abstract

Purpose The knowledge of the link between interbank financing and business cycle fluctuations is important in assessing the stability and soundness of the banking sector. The purpose of this paper is to investigate the simultaneous relationship between interbank financing and the business cycle with respect to the financial structure of the bank-based and market-based systems in European countries by using bank-level data from 2007 to 2011. Design/methodology/approach The study employs an innovative instrumenting technique with an instrument of the financial structure to address the simultaneous determination of interbank financing and the business cycle. Findings The results suggest that banks establish pro-cyclical interbank borrowing by increasing their interbank position during booms and reducing it during downturns. Bank-based system performs better in redistributing the liquidity in the economy than the market-based system when there are imperfectly correlated liquidity shocks across regions during the 2007–2009 financial crisis. Practical implications The improvement of banks’ liquidity risk management should be aligned with a specific financial system. The macro-prudential supervisor should require banks in the market-based system to disclose their interbank position on the extent of risk exposure during the liquidity shock period to stabilize the EU banking industry. Originality/value This study is the first to provide policy makers with some novel empirical results concerning the linkage among bank liquidity, the macroeconomic condition and financial structure.