We study interbank lending and asset sales markets in which banks with surplus liquidity have market power vis-à-vis banks needing liquidity, frictions arise in lending due to moral hazard, and assets are bank-specific. Surplus banks ration lending and instead purchase assets from needy banks, an inefficiency more acute during financial crises. A central bank acting as a lender-of-last-resort can ameliorate this inefficiency provided it is prepared to extend potentially loss-making loans or is better informed than outside markets, as might be the case if it also performs a supervisory role. This rationale for central banking finds support in historical episodes. (JEL E58, G01, G21, G28, L13, N21)
"Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking."
American Economic Journal: Macroeconomics,
Central Banks and Their Policies
Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
Financial Institutions and Services: Government Policy and Regulation
Oligopoly and Other Imperfect Markets
Economic History: Financial Markets and Institutions: U.S.; Canada: Pre-1913