Overnight Interbank Rate Volatility Across Liquidity States: Key Drivers and Policy Implications

Elmir Mukhtarov (), Ali Hajili (), Aygun Garayeva and Vugar Ahmadov
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Elmir Mukhtarov: Central Bank of the Republic of Azerbaijan
Ali Hajili: Central Bank of the Republic of Azerbaijan
Aygun Garayeva: Central Bank of the Republic of Azerbaijan
Vugar Ahmadov: Central Bank of the Republic of Azerbaijan

No 07-2026, IHEID Working Papers from Economics Section, The Graduate Institute of International Studies

Abstract: Effective monetary policy requires maintaining the short-term interbank rate close to the policy rate while limiting its volatility, ensuring smooth transmission, and reducing banks' liquidity and interest rate risks. This paper seeks to identify and explain the drivers of volatility in short-term interbank rates, while examining the impact of the reserve averaging framework on banking sector liquidity. Drawing on evidence from an emerging market, this study demonstrates that deviations of cumulative reserves from their trend exert a significant influence on interbank rate volatility. Specifically, the results identify distinct states in the money market: a high-responsiveness state and a low-responsiveness state, depending on prevailing liquidity conditions. The findings imply that central banks should closely monitor cumulative reserve positions and proactively guide liquidity toward its trend path.

Keywords: overnight interbank rate; required reserve; markov-switching model; liquidity state (search for similar items in EconPapers)
JEL-codes: C22 E53 E58 G21 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2026-03-12
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-tra
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Persistent link: https://EconPapers.repec.org/RePEc:gii:giihei:heidwp07-2026

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