Working Paper Series Over-the-counter Loans, Adverse Selection, and Stigma in the Interbank Market Wp 10-07r Huberto M. Ennis Federal Reserve Bank of Richmond Over-the-counter Loans, Adverse Selection, and Stigma in the Interbank Market *

We study a model of interbank credit where physical and informational frictions limit the opportunities for intertemporal trade among banks and outside investors. Banks obtain loans in an over-the-counter market (involving search, bilateral matching, and negotiations over the terms of the loan) and hold assets of heterogeneous quality that in turn determine their ability to repay those loans. When asset quality is not observable by outside investors, information about the actions taken by a bank in the loan market may influence prices in the asset market. In particular, under some conditions, borrowing from the central bank can be regarded as a negative signal about the quality of the borrower’s assets and banks may be willing to borrow in the market at rates higher than the one offered by the central bank.