Interbank markets and bank bailout policies amid a sovereign debt crisis

Interbank markets have been at the core of the international transmission of recent financial crises, including the euro area sovereign debt crisis. This paper studies the transmission of shocks in a two-country DSGE model where government bonds are used as collateral in interbank markets. We isolate an “interbank collateral channel” of transmission, which works through banks portfolio allocation between loans and government bonds, the resulting value of banks bond holdings and the tightness of collateral constraints in the interbank market. We find that, while in some scenarios this channel compounds a “bank net worth channel” in amplifying negative shocks, in other scenarios the “interbank collateral channel” can mitigate the effects of shocks. Bank bailout policies financed by government debt can erode this stabilizing effect.