Effects of Central Bank Intervention on the Interbank Market during the Sub-Prime Crisis

Abstract

Does central bank intervention improve liquidity in the interbank market during the current sub-prime crisis? To answer this question, we employ a unique dataset which reports trades and quotes of the e-MID, the only electronic, regulated interbank market in the world. Our results show that central bank intervention appears to create greater uncertainty rather than enhancing liquidity as intended. We find that central bank intervention crowds out private liquidity. These results suggest that, when counterparty risk poses systemic risk to the interbank market, the central bank should focus on providing interbank loan guarantees or engage in direct asset purchases rather than simply injecting capital into the system.

Keywords: Central Bank, Interbank Market, Interventions, Volatility