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Bank Liquidity, Interbank Markets and Monetary Policy

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  • Xavier Freixas
  • Antoine Martin
  • David Skeie

Abstract

A major lesson of the recent nancial crisis is that the interbank lending market is crucial for banks facing large uncertainty regarding their liquidity needs. This paper studies the efficiency of the interbank lending market in allocating funds. We consider two diferent types of liquidity shocks leading to diferent implications for optimal policy by the central bank. We show that, when confronted with a distributional liquidity-shock crisis that causes a large disparity in the liquidity held among banks, the central bank should lower the interbank rate. This view implies that the traditional tenet prescribing the separation between prudential regulation and monetary policy should be abandoned. In addition, we show that, during an aggregate liquiditycrisis, central banks should manage the aggregate volume of liquidity. Two diferent instruments, interest rates andliquidityinjection, are therefore required to cope with the two diferent types of liquidity shocks. Finally, we show that failure to cut interest rates during a crisis erodes financial stability by increasing the risk of bank runs.

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Bibliographic Info

Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 429.

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Date of creation: Feb 2010
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Handle: RePEc:bge:wpaper:429

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Keywords: Bank liquidity; interbank markets; central bank policy; …nancial;

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References

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  1. Carmine Di Noia & Giorgio Di Giorgio, 1999. "Should banking supervision and monetary policy tasks be given to different agencies?," Economics Working Papers 411, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Ioannidou, Vasso P., 2005. "Does monetary policy affect the central bank's role in bank supervision?," Journal of Financial Intermediation, Elsevier, vol. 14(1), pages 58-85, January.
  3. Xavier Freixas & Antoine Martin & David Skeie, 2009. "Bank liquidity, interbank markets, and monetary policy," Staff Reports 371, Federal Reserve Bank of New York.
  4. Gorton, Gary & Huang, Lixin, 2006. "Bank panics and the endogeneity of central banking," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1613-1629, October.
  5. Skeie, David R., 2008. "Banking with nominal deposits and inside money," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 562-584, October.
  6. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
  7. Guthrie, Graeme & Wright, Julian, 2000. "Open mouth operations," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 489-516, October.
  8. Antoine Martin, 2009. "Reconciling Bagehot and the Fed's Response to September 11," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(2-3), pages 397-415, 03.
  9. Adam Ashcraft & James McAndrews & David Skeie, 2009. "Precautionary reserves and the interbank market," Staff Reports 370, Federal Reserve Bank of New York.
  10. Xavier Freixas & José Jorge, 2008. "The Role of Interbank Markets in Monetary Policy: A Model with Rationing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(6), pages 1151-1176, 09.
  11. Antoine Martin, 2001. "Liquidity provision vs. deposit insurance : preventing bank panics without moral hazard?," Research Working Paper RWP 01-05, Federal Reserve Bank of Kansas City.
  12. Freixas, X. & Holthausen, C., 2001. "Interbank Market Integration under Asymmetric Information," Papers 74, Quebec a Montreal - Recherche en gestion.
  13. Viral Acharya & Tanju Yorulmazer, 2007. "Cash-in-the-market pricing and optimal resolution of bank failures," Bank of England working papers 328, Bank of England.
  14. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  15. Whitesell, William, 2006. "Interest rate corridors and reserves," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1177-1195, September.
  16. Goodhart, Charles & Schoenmaker, Dirk, 1995. "Should the Functions of Monetary Policy and Banking Supervision Be Separated?," Oxford Economic Papers, Oxford University Press, vol. 47(4), pages 539-60, October.
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  1. Bank Liquidity, Interbank Markets and Monetary Policy
    by Christian Zimmermann in NEP-DGE blog on 2010-04-07 19:34:48
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