Bank Liquidity, Interbank Markets, and Monetary Policy
CentER Discussion Paper Series No. 2010-35S
48 Pages Posted: 22 May 2009 Last revised: 8 Apr 2010
Date Written: February 28, 2010
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.
Keywords: bank liquidity, interbank markets, central bank policy, financial fragility, bank runs
JEL Classification: G21, E43, E52, E58
Suggested Citation: Suggested Citation