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Interbank Market Liquidity and Central Bank Intervention

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  • Franklin Allen
  • Elena Carletti
  • Douglas Gale

Abstract

We develop a simple model of the interbank market where banks trade a long term, safe asset. We show that when there is a lack of opportunities for banks to hedge aggregate and idiosyncratic liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. The model shows also that market freezes, where banks stop trading with each other, can be a feature of the constrained efficient allocation if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand.

Suggested Citation

  • Franklin Allen & Elena Carletti & Douglas Gale, 2009. "Interbank Market Liquidity and Central Bank Intervention," Economics Working Papers ECO2009/09, European University Institute.
    • Handle: RePEc:eui:euiwps:eco2009/09
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    References listed on IDEAS

    as
    1. Gary Gorton & Lixin Huang, 2004. "Liquidity, Efficiency, and Bank Bailouts," American Economic Review, American Economic Association, vol. 94(3), pages 455-483, June.
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    5. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.
    6. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, July.
    7. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    8. Allen, Franklin & Carletti, Elena, 2008. "Mark-to-market accounting and liquidity pricing," Journal of Accounting and Economics, Elsevier, vol. 45(2-3), pages 358-378, August.
    9. Xavier Freixas & Jos… 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, September.
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    12. Viral V. Acharya & Denis Gromb & Tanju Yorulmazer, 2012. "Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(2), pages 184-217, April.
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    More about this item

    Keywords

    interbank market; liquidity; central bank intervention; open market operations;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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