Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking

Denis Gromb, Viral Acharya and Tanju Yorulmazer

No 6984, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study liquidity transfers between banks through the interbank borrowing and asset sale markets when (i) surplus banks providing liquidity have market power, (ii) there are frictions in the lending market 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 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 finds support in historical episodes preceding the modern era of central banking and has implications for recent debates on the supervisory and lender-of-last-resort roles of central banks.

Keywords: Asset specificity; Central bank; Competition; Interbank lending; Lender of last resort; market power (search for similar items in EconPapers)
JEL-codes: D62 E58 G21 G28 G38 (search for similar items in EconPapers)
Date: 2008-10
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (42)

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Journal Article: Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking (2012)
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