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An important motivation for financial regulation is the premise that the externality imposed by bank failures on the financial system is not reflected in market pricing. In this study we empirically assess this premise by studying whether systemic contagion losses are reflected in bilateral prices charged on interbank markets. We study this question within a simultaneous equation model in order to account for the endogeneity induced by the simultaneous determination of interbank lending and deposit rates. Our empirical inference suggests that systemic externalities are not internalized on interbank markets, highlighting the existence of a market failure with respect to systemic risk.
