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
Date Written: September 1, 2008
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: Suggested Citation