The effect of the central bank’s standing facilities on interbank lending and bank liquidity holding

Abstract

How does the central bank influence interbank lending? The central bank's policy rates determine the attractiveness of the standing facilities compared with the interbank market. Therefore, by choosing the policy rates the central bank affects the number of banks using the standing facilities and the number of banks using the interbank market. There is also a second channel. The policy rates may influence bank liquidity holding and thus the chances that interbank lending occurs. To address both channels, bank liquidity holding is endogenous in the presented model. The results show that liquidity is not held to insure against idiosyncratic risk but to lend to the interbank market in case counterparty risk is not too high. If banks expect interbank lending to be sufficiently likely and profitable, a smooth liquidity transfer at the interbank market is guaranteed. The central bank can create such a situation under the constraint that counterparty risk is moderate and counterparty risk perceptions are not too distorted. If, however, counterparty risk is perceived to be too large, this may result in liquidity hoarding. KeywordsInterbank market • Liquidity holding • Standing facilities JEL Classification E43 • E58 • G21 The author would like to thank an anonymous referee, Diemo Dietrich, Uwe Vollmer, Harald Wiese, and the participants of the 8th RGS Doctoral Conference in Economics, the Doctoral Seminars at IWH and Leipzig University, and the Annual Congress 2015 of the Swiss Society of Economics and Statistics for helpful comments and suggestions, while retaining responsibility for all errors..

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