Paper #1202

Title:

Bank liquidity, interbank markets and monetary policy

Authors:

Xavier Freixas, Antoine Martin and David Skeie

Date:

February 2010

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 different implications for optimal policy by the central bank. We show that, when confronted with a distributional 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 monetary policy should be abandoned. In addition, we show that, during an aggregate liquidity crisis, central banks should manage the aggregate volume of liquidity. Two different instruments, interest rates and liquidity injection, are therefore required to cope with the two different 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.

Keywords:

Bank liquidity, interbank markets, central bank policy, financial fragility, bank runs.

JEL codes:

G21, E43, E44, E52, E58

Area of Research:

Finance and Accounting

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