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Bank Liquidity, Interbank Markets and Monetary Policy

  • Xavier Freixas
  • Antoine Martin
  • David Skeie

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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File URL: http://research.barcelonagse.eu/tmp/working_papers/429.pdf
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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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  1. 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.
  2. 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.
  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. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  5. 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.
  6. Whitesell, William, 2006. "Interest rate corridors and reserves," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1177-1195, September.
  7. Guthrie, Graeme & Wright, Julian, 2000. "Open mouth operations," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 489-516, October.
  8. Gary Gorton & Lixin Huang, 2002. "Bank Panics and the Endogeneity of Central Banking," NBER Working Papers 9102, National Bureau of Economic Research, Inc.
  9. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  10. Freixas, Xavier & Holthausen, Cornelia, 2001. "Interbank market integration under asymmetric information," Working Paper Series 0074, European Central Bank.
  11. 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.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. Skeie, David R., 2008. "Banking with nominal deposits and inside money," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 562-584, October.
  17. 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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