Peer Monitoring or Contagion? Interbank Market Exposure and Bank Risk

We test if interconnectedness in the interbank market is a channel through which banks affect each others riskiness. The evidence is based on quarterly bilateral exposures of all banks active in the Dutch interbank market between 1998 and 2008. A spatial lag model, borrowed from regional science, is used to test if z -scores of other banks affect individual bank's z -scores through the network of the interbank market. Larger dependence on interbank borrowing and lending increases bank risk. But only interbank funding exposures to other banks in the system exhibit significant spill-over coefficients. Spatial lags for lending are insignificant while borrowing from other banks reduces individual bank risk if neighbors are stable, too. Vice versa, stability shocks at interbank counterparties in the system spill over through the liability side of banks balance sheets.