Monetary Policy Transmission with Interbank Market Fragmentation

Abstract

This paper shows how interbank market fragmentation disrupts the transmission of monetary policy. Fragmentation is the fact that banks, depending on their country of location, have different probabilities of default on their interbank borrowings. Once fragmentation is introduced into standard theoretical models of monetary policy implementation, excess liquidity arises endogenously. This leads short‐term interest rates to depart from the central bank policy rates. Using data on monetary policy operations, I show that this mechanism has been at work in the euro area since 2008. The model is used to analyze conventional and unconventional monetary policy measures.

Relationship Between Short-Term Interest Rates and Excess Reserves: A Logistic Approach

“…The logistic function is consistent with the models of Bech and Monnet (2015) and Vari (2016). The models presented in these papers, in fact, derive theoretical relationships between excess reserves and interest rate that are close to the logistic function.…”

Do conventional monetary policy instruments matter in unconventional times?

“…25 Figure 4 has revealed different uses of central bank liquidity across euro area countries. Figure A1 in the Web Appendix provides some additional evidence of these differences by showing reserve holdings/ borrowing of domestic MFIs at/ from the national central bank for the cases of Germany and Spain (see also Vari 2016). 26 For brevity, these regression results are not reported but can be obtained upon request.…”

Liquidity Ratios as Monetary Policy Tools

“…In this section, we discuss how securities reserve requirements impact short-term money market rates. Our model draws on Huberto M. Ennis and Todd Keister (2008), Bech and Keister (2013), and Vari (2019). A key modeling assumption of our model is that securities can be pledged to borrow from the central bank.…”