Does the bank risk concentration freeze the interbank system?

• We explore theoretically the interbank functioning with risks concentration.
• Banks are exposed to credit and liquidity risk that correlate over the business cycle.
• Risk concentration makes interbank markets fragile and welfare decreases.

Probably, one test of the stability of the banking system is to evaluate how risky assets are distributed across banks’ portfolios and the implications for the contagion via interbank relations. This paper explores theoretically a bank sector with risks concentration and the functioning of interbank markets. It employs a simple model where banks are exposed to both credit and liquidity risk that suddenly correlate over the business cycle. We show that risk concentration makes interbank market breakdowns more likely and welfare monotonically decreases in risk concentration.