Bank Liquidity, Interbank Markets, and Monetary Policy
Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR)
Federal Reserve Bank of New York - Research and Statistics
David R. Skeie
Federal Reserve Bank of New York
February 28, 2010
FRB of New York Staff Report No. 371
European Banking Center Discussion Paper No. 2010-08S
CentER Discussion Paper Series No. 2010-35S
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.
Number of Pages in PDF File: 48
Keywords: bank liquidity, interbank markets, central bank policy, financial fragility, bank runs
JEL Classification: G21, E43, E52, E58working papers series
Date posted: May 22, 2009 ; Last revised: April 8, 2010
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