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Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking


Viral V. Acharya


New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Denis Gromb


London Business School; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Tanju Yorulmazer


Federal Reserve Bank of New York

September 1, 2008


Abstract:     
We study liquidity transfers between banks through the interbank borrowing and asset sale markets when (i) surplus banks providing liquidity have market power, (ii) there are frictions in the lending market due to moral hazard, and (iii) assets are bank-specific. We show that when the outside options of needy banks are weak, surplus banks may strategically under-provide lending, thereby inducing inefficient sales of bank-specific assets. A central bank can ameliorate this inefficiency by standing ready to lend to needy banks, provided it has greater information about banks (e.g., through supervision) compared to outside markets, or is prepared to extend loss-making loans. The public provision of liquidity to banks, in fact its mere credibility, can thus improve the private allocation of liquidity among banks. This rationale for central banking finds support in historical episodes preceding the modern era of central banking and has implications for recent debates on the supervisory and lender-of-last-resort roles of central banks.

Number of Pages in PDF File: 42

Keywords: Competition, Interbank lending, Market power, Asset specificity, Central bank, Lender of last resort

JEL Classification: G21, G28, G38, E58, D62

working papers series


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Date posted: September 29, 2008 ; Last revised: November 30, 2009

Suggested Citation

Acharya, Viral V. and Gromb, Denis and Yorulmazer, Tanju, Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking (September 1, 2008). Available at SSRN: http://ssrn.com/abstract=1275136 or http://dx.doi.org/10.2139/ssrn.1275136

Contact Information

Viral V. Acharya (Contact Author)
New York University - Leonard N. Stern School of Business ( email )
44 West 4th Street
New York, NY NY 10012
United States
HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
New York University (NYU) - Department of Finance
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
Denis Gromb
London Business School ( email )
Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7262 5050 x3545 (Phone)
+44 20 7724 3317 (Fax)
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
HOME PAGE: http://www.ecgi.org
Tanju Yorulmazer
Federal Reserve Bank of New York ( email )
33 Liberty Street
New York, NY 10045
United States
HOME PAGE: http://www.ny.frb.org/research/economists/yorulmazer/index.html
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