TAILIEUCHUNG - Federal Reserve Bank of New York Staff Reports: Bank Liquidity, Interbank Markets, and Monetary Policy

But how far should the public sector go in defining the terms of maturity transformation?. It would be reassuring to imagine that underlying saving and investment propensities of the private sector define the real interest rate in normal times. Keynes threw some doubt on this classical view. In addition, the fact is that government policies nowadays dominate the terms of maturity transformation in modern economies. Very large government debt defines the yield curve. Prudential regulations have a pervasive effect: many supervisory rules for financial firms in effect create a near-captive demand of regulated entities for government paper. In some. | Federal Reserve Bank of New York Staff Reports Bank Liquidity Interbank Markets and Monetary Policy Xavier Freixas Antoine Martin David Skeie Staff Report no. 371 May 2009 Revised September 2009 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Bank Liquidity Interbank Markets and Monetary Policy Xavier Freixas Antoine Martin and David Skeie Federal Reserve Bank of New York Staff Reports no. 371 May 2009 revised September 2009 JEL classification G21 E43 E52 E58 Abstract A major lesson of the recent financial crisis is that the interbank lending market is crucial for banks that face uncertainty regarding their liquidity needs. This paper examines the efficiency of the interbank lending market in allocating funds and the optimal policy of a central bank in response to liquidity shocks. We show that when confronted with a distributional liquidity-shock crisis that causes a large disparity in the liquidity held by different banks a central bank should lower the interbank rate. This view implies that the traditional separation between prudential regulation and monetary policy should be rethought. In addition we show that during an aggregate liquidity crisis central banks should manage the aggregate volume of liquidity. Therefore two different instruments interest rates and liquidity injection are 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 probability of bank runs. Key words bank liquidity interbank markets central bank policy financial fragility bank runs Freixas Universitat Pompeu Fabra e-mail .

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