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Interbank Market Liquidity and Central Bank Intervention

  • Franklin Allen
  • Elena Carletti
  • Douglas Gale

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.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2009/09.

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Date of creation: 2009
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Handle: RePEc:eui:euiwps:eco2009/09
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  1. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  2. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Liquidity Shortages and Banking Crises," NBER Working Papers 10071, National Bureau of Economic Research, Inc.
  3. Gary Gorton & Lixin Huang, 2004. "Liquidity, Efficiency, and Bank Bailouts," American Economic Review, American Economic Association, vol. 94(3), pages 455-483, June.
  4. Allen, Franklin & Carletti, Elena, 2006. "Mark-to-market accounting and liquidity pricing," CFS Working Paper Series 2006/17, Center for Financial Studies (CFS).
  5. 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.
  6. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
  7. Mark J. Flannery, 1996. "Financial crises, payment system problems, and discount window lending," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 804-831.
  8. Marvin Goodfriend & Robert G. King, 1988. "Financial deregulation, monetary policy, and central banking," Working Paper 88-01, Federal Reserve Bank of Richmond.
  9. Rafael Repullo, 2005. "Liquidity, Risk-Taking, And The Lender Of Last Resort," Working Papers wp2005_0504, CEMFI.
  10. repec:dgr:kubcen:201035s is not listed on IDEAS
  11. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  12. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.
  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. Acharya, Viral V & Gromb, Denis & Yorulmazer, Tanju, 2008. "Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking," CEPR Discussion Papers 6984, C.E.P.R. Discussion Papers.
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