Explaining breakdowns in interbank lending: A bilateral bargaining model

- We use a bilateral bargaining model to analyze interbank lending.
- We apply the Nash bargaining solution.
- The higher the borrowing bank's project return, the more likely the interbank loan.
- The higher the borrowing bank's success probability, the more likely the interbank loan.
- The lending bank's success probability is irrelevant.

The paper provides a simple model for interbank loans. Since interbank trades are usually over-the-counter transactions, we use a bilateral bargaining model and apply the Nash bargaining solution. We determine the threat points and the bargaining frontier of debtor and creditor banks. We ask under which conditions interbank lending will break down.