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Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking

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Author Info
Acharya, Viral V
Gromb, Denis
Yorulmazer, Tanju

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Abstract

We study liquidity transfers between banks through the interbank borrowing and asset sale markets when (i) surplus banks providing liquidity have market power, (ii) there are frictions in the lending market due to moral hazard, and (iii) assets are bank-specific. We show that when the outside options of needy banks are weak, surplus banks may strategically under-provide lending, thereby inducing inefficient sales of bank-specific assets. A central bank can ameliorate this inefficiency by standing ready to lend to needy banks, provided it has greater information about banks (e.g., through supervision) compared to outside markets, or is prepared to extend loss- making loans. The public provision of liquidity to banks, in fact its mere credibility, can thus improve the private allocation of liquidity among banks. This rationale for central banking finds support in historical episodes preceding the modern era of central banking and has implications for recent debates on the supervisory and lender-of-last-resort roles of central banks.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6984.

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Date of creation: Oct 2008
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Handle: RePEc:cpr:ceprdp:6984

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Related research
Keywords: Asset specificity; Central bank; Competition; Interbank lending; Lender of last resort; Market power;

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Find related papers by JEL classification:
D62 - Microeconomics - - Welfare Economics - - - Externalities
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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  1. Pasricha, Gurnain, 2009. "Bank Competition and International Financial Integration: Evidence using a new Index," MPRA Paper 16767, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  2. Frank Milne, 2008. "Credit Crises, Risk Management Systems and Liquidity Modelling," Working Papers 1, John Deutsch Institute for the Study of Economic Policy. [Downloadable!]
  3. Piffaretti, Nadia F., 2008. "Reshaping the International Monetary Architecture and Addressing Global Imbalances: Lessons from the Keynes Plan," MPRA Paper 12165, University Library of Munich, Germany. [Downloadable!]
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