The Risk Alleviating Role of Interbank Market Lending in Central and Eastern European Countries

The banking sectors in several Central and Eastern European countries are characterized by a two-tier structure, in which a few large banks dominate the deposit market but are very inactive in the loan market with private borrowers, while many small banks engage in lending but have only small shares of the deposit market. The large banks act as net lenders in the interbank market, while small banks are net borrowers in the market. Typically, the former banks are incumbent institutions from pre-transition times, while the later are new institutions. In this paper, we ask whether this two-tier structure and the resulting interbank trade has any important risk alleviating effects on the performance of the banking sector. Specifically, we consider the effects on the lending activities of the small banks. We present a model of the credit market based on asymmetric information and moral hazard. Assuming that large banks have monitoring costs benefits compared to depositors regarding the lending activities of the other banks, we show that the two-tier structure induces small banks to engage in less risky lending activities than small banks that finance themselves predominantly in the deposit market. We test this and related hypotheses using balance sheet data from banks in 10 EU accession candidate countries. This allows us to compare the financial activities of banks in countries where a two-tier structure prevails with those of small banks in markets where such a pattern is not observed. The results generally confirm the main hypothesis of the model.