The appropriate response of a central banks interest rate policy to banking crises is the subject of a continuing and important debate. A standard view is that monetary policy should play a role only if a financial disruption directly affects inflation or the real economy; monetary policy should not be used to alleviate financial distress per se. Additionally, several studies on interlinkages between monetary policy and financial stability policy recommend the complete separation of the two, with evidence of higher and more volatile inflation rates in countries where the central bank is in charge of banking stability.
This view of monetary policy is challenged by observations that during a banking crisis, interbank interest rates often appear to be a key instrument used by central banks for limiting threats to financial stability. During the recent crisis starting in August 2007, interest rate setting in both the U.S. and the E.U. appeared to be geared heavily toward alleviating stress in the banking system. This also appears to be the case in previous financial disruptions, as Goodfriend (2002) states: Consider the fact that the Fed cut interest rates sharply in response to two of the most serious financial crises in recent years: the October 1987 stock market break and the turmoil following the Russian default in 1998. The practice of reducing interbank rates during financial turmoil also challenges the long debated view originated by Bagehot (1873) that central banks should provide liquidity to banks at high penalty interest rates (see Martin 2009, for example).
In order to understand the role for monetary policy during banking crises, it is important to have a framework to address the issue in its most basic form. Interbank lending markets are a critical source of external liquidity for banks during financial turmoil, and interbank interest rates are the fundamental instrument of monetary policy. In our paper, we develop a model for studying the role of optimal central bank interest rate policy in interbank markets in the event of both idiosyncratic and aggregate liquidity shocks. We examine whether the interbank market can provide optimal liquidity to banks during a crisis. We question whether access to interbank market liquidity helps or hurts banks incentives to hold liquid assets internally ex ante, and we ask if central bank policy can help.
Our main results are that 1) an interbank market can be part of an optimal institutional arrangement, 2) the central bank can achieve the full information first best allocation and should use different tools to respond to different types of shocks, and 3) failure by the central bank to follow the optimal policy can lead to financial fragility. In particular, we show that there exists a first best equilibrium in which the central bank sets low interbank rates during idiosyncratic disruptions to enable efficient redistribution of liquidity, sets high rates during non disruptive times using a symmetric rate policy to induce banks to hold liquid assets ex ante, and injects additional liquidity into the banking system during aggregate shocks.
Intuition for our results can be gained by understanding the role of banks and the interbank market in our model. Under incomplete markets, a primary role for banks is to provide greater risk sharing and liquidity to depositors who face uninsurable idiosyncratic liquidity shocks. During financial disruptions, which we think of as states when banks face considerable uncertainty regarding their need for liquid assets, banks themselves may have large borrowing needs in the interbank market. We show that an interbank market can achieve the optimal allocationo allowing banks to provide efficient risk sharing to their depositors and insuring banks against idiosyncratic liquidity shockso provided that the interest rate in this market is state dependent and low in states of financial disruption. The need for a state dependent interest rate suggests a role for the central bank.
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Bank liquidity, interbank markets, and monetary policy
