Interbank Market Freezes and Creditor Runs
We model the interplay between trade in the interbank market and creditor runs on financial institutions. We show that the feedback between them can amplify a small shock into "interbank market freezing" with "liquidity evaporating" Credit crunches of the interbank market drive up the interbank rate. For an individual institution, a higher interbank rate meaning a higher funding cost results in more severe coordination problems among creditors in debt rollover decisions. Creditors thus behave more conservatively and run more often. Facing an increased chance of creditor runs, institutions demand more and supply less liquidity, tightening the interbank market. Our model helps to explain the occurrence of a crisis and amplification, demonstrating that banking crises arise from a shrinking of the pool of aggregate liquidity.