The interplay between the interbank market and banking regulations and monetary policies

Interbank markets provide critical facilities for the banking system to manage, pool and redistribute assets and liabilities. We provide a selective survey of the literature on overnight interbank market, mainly based on two markets - US Federal funds and the Euro Overnight Index Average (including its predecessors in individual euro zone countries). We outline the typical structure of overnight markets including the networking relationships involved. We set out a simple theoretical model based on the reserve management approach and survey the empirical literature on the determination of the overnight rate. Overall, theliterature survey highlights two important implications of the interbank market:monetary policy; and bank regulation. First, it is noted that the overnight interbank market is closely linked with the market for bank reserves, providing "next-to-last-resort" borrowing facilities for commercial banks. It plays a crucial role in monetary policy and is an integral part if the payments system as daily transactions are settled through movements in bank reserves. 

However, given that it was the freezing up of interbank lending that heralded the onset of the 2007-08 financial crisis; it is not altogether clear whether, post-crisis, the interbank market  still plays an important monetary policy role. Second, on implications for bank regulation, the literature flags up two competing views: one view is that the interbank market still plays an important monetary policy rol. Second, in the implications for bank regulation, the literature flags up two competing views: one view is that the interbank market may propagate bank contagion; the other view is that, on the contrary, the market provides a mechanism for peer-monitoring among the participating banks and thus amounts to self-regulation. We investigate the two competing views using a unique set of quartely data on 43 Kenyan banks which participated in interbank transactions during 2003Q1 - 2011Q1. We uncover a stable inverse relationship between interbank activity and bank risk levels, even after controlling for diferences in bank characteristics. Our results suggest that regulators can use the dynamic interbank borrowing activities among large and small banks as market signals to identify banks that are perceived as risky.