Imperfect Competition in the Interbank Market for Liquidity as Arationale for Central Banking
42 Pages Posted: 8 Feb 2010
Date Written: October 23, 2009
We study liquidity transfers between banks through the interbank borrowing and asset sale markets when, (i) surplus banks providingliquidity have market power, ii) there are frictions in the lendingmarket 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 potentially 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 funds support in historical episodes preceding the modern era of central banking and has implications forrecent debates on the supervisory and lender-of-last-resort roles of central banks.
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