Bank Liquidity, Interbank Markets, and Monetary Policy

X. Freixas, A. Martin, D. Skeie

    Research output: Working paperDiscussion paperOther research output

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    Abstract

    A major lesson of the recent financial crisis is that the interbank lending market is crucial for banks facing large uncertainty regarding their liquidity needs. This paper studies the efficiency of the interbank lending market in allocating funds. We consider two different types of liquidity shocks leading to di¤erent implications for optimal policy by the central bank. We show that, when confronted with a distribu- tional liquidity-shock crisis that causes a large disparity in the liquidity held among banks, the central bank should lower the interbank rate. This view implies that the traditional tenet prescribing the separation between prudential regulation and mon- etary policy should be abandoned. In addition, we show that, during an aggregate liquidity crisis, central banks should manage the aggregate volume of liquidity. Two di¤erent instruments, interest rates and liquidity injection, are therefore required to cope with the two di¤erent types of liquidity shocks. Finally, we show that failure to cut interest rates during a crisis erodes financial stability by increasing the risk of bank runs.
    Original languageEnglish
    Place of PublicationTilburg
    PublisherVakgroep CentER
    Number of pages48
    Volume2010-35S
    Publication statusPublished - 2010

    Publication series

    NameCentER Discussion Paper
    Volume2010-35S

    Fingerprint

    Liquidity
    Monetary policy
    Interbank market
    Liquidity shocks
    Central bank
    Interest rates
    Lending
    Liquidity crisis
    Prudential regulation
    Uncertainty
    Financial crisis
    Bank runs
    Financial stability
    Injection
    Prescribing
    Optimal policy

    Keywords

    • bank liquidity
    • interbank markets
    • central bank policy
    • financial fragility
    • bank runs

    Cite this

    Freixas, X., Martin, A., & Skeie, D. (2010). Bank Liquidity, Interbank Markets, and Monetary Policy. (CentER Discussion Paper; Vol. 2010-35S). Tilburg: Vakgroep CentER.
    Freixas, X. ; Martin, A. ; Skeie, D. / Bank Liquidity, Interbank Markets, and Monetary Policy. Tilburg : Vakgroep CentER, 2010. (CentER Discussion Paper).
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    Freixas, X, Martin, A & Skeie, D 2010 'Bank Liquidity, Interbank Markets, and Monetary Policy' CentER Discussion Paper, vol. 2010-35S, Vakgroep CentER, Tilburg.

    Bank Liquidity, Interbank Markets, and Monetary Policy. / Freixas, X.; Martin, A.; Skeie, D.

    Tilburg : Vakgroep CentER, 2010. (CentER Discussion Paper; Vol. 2010-35S).

    Research output: Working paperDiscussion paperOther research output

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    AB - A major lesson of the recent financial crisis is that the interbank lending market is crucial for banks facing large uncertainty regarding their liquidity needs. This paper studies the efficiency of the interbank lending market in allocating funds. We consider two different types of liquidity shocks leading to di¤erent implications for optimal policy by the central bank. We show that, when confronted with a distribu- tional liquidity-shock crisis that causes a large disparity in the liquidity held among banks, the central bank should lower the interbank rate. This view implies that the traditional tenet prescribing the separation between prudential regulation and mon- etary policy should be abandoned. In addition, we show that, during an aggregate liquidity crisis, central banks should manage the aggregate volume of liquidity. Two di¤erent instruments, interest rates and liquidity injection, are therefore required to cope with the two di¤erent types of liquidity shocks. Finally, we show that failure to cut interest rates during a crisis erodes financial stability by increasing the risk of bank runs.

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    KW - bank runs

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    Freixas X, Martin A, Skeie D. Bank Liquidity, Interbank Markets, and Monetary Policy. Tilburg: Vakgroep CentER. 2010. (CentER Discussion Paper).