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

42 Pages Posted: 29 Sep 2008 Last revised: 1 Oct 2015

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

University of Amsterdam - Faculty of Economics and Business (FEB)

Multiple version iconThere are 3 versions of this paper

Date Written: 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.

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

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

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: https://ssrn.com/abstract=1275136 or http://dx.doi.org/10.2139/ssrn.1275136

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

University of Amsterdam - Faculty of Economics and Business (FEB) ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

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