Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking

We study liquidity transfers between banks through the interbank borrowing and asset sale markets when (i) surplus banks providing liquidity have market power, (ii) there are frictions in the lending market due to moral hazard, and (iii) assets are bankspecific. We show that when the outside options of needy banks are weak, sur plus banks may strategically underprovide lending, thereby inducing inefficient sales of bankspecific assets. A central bank can ameliorate this inefficiency by standing ready to lend to needy banks, provided it has greater information about banks (e.g., through supervision) compared to outside markets, or is prepared to extend loss making loans. The public provision of liquidity to banks, in fact its mere credibility, can thus improve the private allocation of liquidity among banks. This rationale for central banking finds support in historical episodes preceding the modern era of central banking and has implications for recent debates on the supervisory and lenderoflastresort roles of central banks