The interbank market, Keynes’s degree of confidence and the link between banks’ liquidity and solvency

By Konstantinos Loizos

PKES Working Paper 2017

August 2020

The link between banks’ liquidity and solvency is not adequately addressed in the literature, despite the central role of the interbank market in the spread of the recent crisis. This paper proposes a possible way by which the interbank rate and the required return on equity capital are determined, and are related to each other. Thereby, a link between liquidity and insolvency risk is derived on the grounds of Keynes's concept of ‘degree of confidence’ on held expectations about economic prospects. High degree of confidence and trust prevailing in the interbank market makes risk sharing possible at prices which render bank capital regulation ineffective in the rising phase of the cycle, and overly restricted in the downswing. Basel’s III higher capital, liquidity and leverage ratios might not be enough if measures, in the sense of Minsky’s Big Government-Big Bank, targeting overconfidence in booms and redressing the lack of confidence in the downturns are not taken into account.

Keywords: Degree of confidence, Interbank market, Liquidity preference, Insolvency risk, Financial cycles

JEL classification: E12 E32 G21