Interbank Market Failure and the Effects of the Basel III Regulations in a DSGE Model for Iran

Abstract

In order to facilitate transactions among banks, the interbank market has been established in Iran since 2008. The primary objective of this market is to eliminate banking system liquidity deficiencies at a rate chosen by the Central bank of Iran. The importance of this rate is that it affects market interest rates through its effects on banks' balance sheets. Banks' balance sheets are also influenced by banking regulation, such as Basel regulations; thus, this study was aimed to investigate the effects of the interbank market in Iran by imposing Basel III regulations on the banking system. For this purpose, a dynamic stochastic general equilibrium model (DSGE) was designed that included the interbank market. The structural parameters of the designed model were estimated using the Bayesian method and the quarterly data on the period 2008-2015. Afterward, the effect of a positive interbank innovation on the economy's dynamics was examined. The results showed that an increase in the interbank rate led to instability in the economy. It was concluded that an increase in the liquidity and capital adequacy requirement, as mentioned in the Basel III regulations, would reduce the negative effects of interbank shocks on macroeconomic variables and the economy would naturally become more stable.