Abstract

The interbank market (IBM) is a crucial source of funding for banks, but market activity has shrunk considerably after Lehman Brothers' filled for bankruptcy in 2008. Consequently, the IBM market has also suffered from insufficient liquidity since this event. An important aim of this paper is to identify the conditions that have helped lead to an improvement in IBM liquidity via establishing a relationship. Although engaging in an interbank relationship is costly, it can stimulate lenders to participate in the IBM since relationships allow lenders to be more confident in their assessment about the borrower's quality. The model presented in this paper addresses the choice of a transaction or a relationship in lending using a single-choice setting prior to resolving the uncertainty about a borrower's quality. In such an uncertain setting, ambiguity-averse lenders are less confident than risk-averse ones: these ambiguity-averse lenders consider a range of distributions by which they behave cautiously when deciding on IBM participation. The model's equilibrium indicates under which conditions establishing a relationship is preferred to transactional banking, thus mitigating the market failure of liquidity shortages. Generally, relationship banking is preferred to transactional banking when the lender benefits in terms of confidence and precision when assessing a borrower's quality. It is especially important at times of deteriorating trust but becomes less evident the more severe the shock due to ambiguity is. For extreme levels, the improvement in a lender's confidence level is too low via relationships.