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Bank liquidity, interbank markets, and monetary policy

  • Xavier Freixas
  • Antoine Martin
  • David Skeie

A major lesson of the recent financial crisis is that the ability of banks to withstand liquidity shocks and to provide lending to one another is crucial for financial stability. This paper studies the functioning of the interbank lending market and the optimal policy of a central bank in response to both idiosyncratic and aggregate shocks. In particular, we consider how the interbank market affects a bank's choice between holding liquid assets ex ante and acquiring such assets in the market ex post. We show that a central bank should use different tools to manage different types of shocks. Specifically, it should respond to idiosyncratic shocks by lowering the interest rate in the interbank market and address aggregate shocks by injecting liquid assets into the banking system. We also show that failure to adopt the optimal policy can lead to financial fragility.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 371.

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Date of creation: 2009
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Handle: RePEc:fip:fednsr:371
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  1. Skeie, David R., 2008. "Banking with nominal deposits and inside money," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 562-584, October.
  2. Freixas, X. & Holthausen, C., 2001. "Interbank Market Integration under Asymmetric Information," Papers 74, Quebec a Montreal - Recherche en gestion.
  3. 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.
  4. 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.
  5. Di Noia, Carmine & Di Giorgio, Giorgio, 1999. "Should Banking Supervision and Monetary Policy Tasks Be Given to Different Agencies?," International Finance, Wiley Blackwell, vol. 2(3), pages 361-78, November.
  6. 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.
  7. Gary Gorton & Lixin Huang, 2002. "Bank Panics and the Endogeneity of Central Banking," Center for Financial Institutions Working Papers 02-29, Wharton School Center for Financial Institutions, University of Pennsylvania.
  8. 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.
  9. Ioannidou, Vasso P., 2005. "Does monetary policy affect the central bank's role in bank supervision?," Journal of Financial Intermediation, Elsevier, vol. 14(1), pages 58-85, January.
  10. 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.
  11. Xavier Freixas & Antoine Martin & David Skeie, 2010. "Bank liquidity, interbank markets and monetary policy," Economics Working Papers 1202, Department of Economics and Business, Universitat Pompeu Fabra.
  12. 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.
  13. Guthrie, Graeme & Wright, Julian, 2000. "Open mouth operations," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 489-516, October.
  14. 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.
  15. Whitesell, William, 2006. "Interest rate corridors and reserves," Journal of Monetary Economics, Elsevier, vol. 53(6), pages 1177-1195, September.
  16. 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.
  17. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
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