Interbank Credit and the Money Manufacturing Process. A Systemic Perspective on Financial Stability

Abstract: Interbank lending and borrowing occur when financial institutions seek to settle and refinance their mutual positions over time and circumstances. This interactive process involves money creation at the aggregate level. Coordination mismatch on interbank credit may trigger systemic crises. This happened when, since summer 2007, interbank credit coordination did not longer work smoothly across financial institutions, eventually requiring exceptional monetary policies by central banks, and guarantee and bailout interventions by governments. Our article develops an interacting heterogeneous agents-based model of interbank credit coordination under minimal institutions. First, we explore the link between interbank credit coordination and the money generation process. Contrary to received understanding, interbank credit has the capacity to make the monetary system unbound. Second, we develop simulation analysis on imperfect interbank credit coordination, studying impact of interbank dynamics on financial stability and resilience at individual and aggregate levels. Systemically destabilizing forces prove to be related to the working of the banking system over time, especially interbank coordination conditions and circumstances.