Market structure, interest rates and the risk of financial contagion: An examination of the Swedish overnight market

Abstract: The current financial crisis has demonstrated the importance of well functioning interbank markets for the financial system. However, as interbank exposures are often uncollateralized and of large amounts these markets constitute a channel through which financial contagion can spread. This paper uses unique transaction level data from the Swedish payment system RIX to study the interbank segment of the Swedish market for overnight deposits. In a first part, the microstructure of the market is assessed. Specifically, market size, interbank activity, counterparty relationships and the pricing of overnight loans are examined. In a second part, the risk of financial contagion to the Swedish banking sector implied by the overnight loan exposures is analyzed using a round-by-round simulation. The paper shows that most banks use the overnight market nearly every day. Still, most of the activity in terms of transaction value is concentrated to an inner tier of a few large banks. Indications of systematic lending and borrowing patterns and interbank relationships are presented. The majority of the overnight loans are found to be made to the repo rate, without a risk premium, indicating that market participants meet the “gentlemen’s agreement” that is said to exist between them. Furthermore, the paper finds that subsequent failures due to the unexpected failure of one of the participating banks are unlikely, however possible. The greatest risk of financial contagion is identified to be associated with specific institutions and can not be related directly to the size of the total overnight exposure or number of exposures. The data used cover the period July 2007 to October 2008, i.e., the first 15 months of the current financial crisis. Despite the stress and uncertainty characterizing the surrounding, the paper finds nearly no indications of changes in the behavior of financial institutions in the overnight market during the period.