Interbank Borrowing and Bank Liquidity Risk

To avoid illiquidity spillovers and basis risk in swaps, interbank lenders are especially cautious about whether interbank borrowers can meet their claims. This paper is about examining whether the incentive of interbank lenders to penalize risky borrowers can reduce the liquidity risk-taking of borrowers. We find that interbank borrowers, especially small and medium banks, manage their liquidity risks more prudently than their counterparts. This phenomenon is especially significant for borrowers with high information asymmetry, low liquidity buffers and high funding gaps. Our results suggest that interbank exposure reduces the asset, funding, and off-balance sheet liquidity risks of small and medium borrowing banks, and can therefore supplement regulatory liquidity requirements, which target only the largest banks