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Bank Liquidity, Interbank Markets, and Monetary Policy

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Author Info

  • Freixas, X.
  • Martin, A.
  • Skeie, D.

    (Tilburg University, Center for Economic Research)

Abstract

A major lesson of the recent financial 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 different types of liquidity shocks leading to di¤erent implications for optimal policy by the central bank. We show that, when confronted with a distribu- tional 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 mon- etary policy should be abandoned. In addition, we show that, during an aggregate liquidity crisis, central banks should manage the aggregate volume of liquidity. Two di¤erent instruments, interest rates and liquidity injection, are therefore required to cope with the two di¤erent 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 Tilburg University, Center for Economic Research in its series Discussion Paper with number 2010-35S.

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Date of creation: 2010
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Handle: RePEc:dgr:kubcen:201035s

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Web page: http://center.uvt.nl

Related research

Keywords: bank liquidity; interbank markets; central bank policy; financial fragility; bank runs;

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References

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  1. 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.
  2. Gary Gorton & Lixin Huang, 2002. "Bank Panics and the Endogeneity of Central Banking," NBER Working Papers 9102, National Bureau of Economic Research, Inc.
  3. Ioannidou, V., 2002. "Does Monetary Policy Affect the Central Bank's Role in Bank Supervision?," Discussion Paper 2002-54, Tilburg University, Center for Economic Research.
  4. Freixas, X. & Martin, A. & Skeie, D., 2010. "Bank Liquidity, Interbank Markets, and Monetary Policy," Discussion Paper 2010-35S, Tilburg University, Center for Economic Research.
  5. 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.
  6. 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.
  7. Whitesell, William, 2006. "Interest rate corridors and reserves," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1177-1195, September.
  8. David R. Skeie, 2008. "Banking with nominal deposits and inside money," Staff Reports 242, Federal Reserve Bank of New York.
  9. 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.
  10. Xavier Freixas, 2005. "Interbank Market Integration under Asymmetric Information," Review of Financial Studies, Society for Financial Studies, vol. 18(2), pages 459-490.
  11. Guthrie, Graeme & Wright, Julian, 2000. "Open mouth operations," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 489-516, October.
  12. 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.
  13. Adam Ashcraft & James Mcandrews & David Skeie, 2011. "Precautionary Reserves and the Interbank Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 311-348, October.
  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. 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.
  16. 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.
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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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