The Role of Interbank Markets in Monetary Policy: A Model with Rationing

By Freixas, Xavier; Jorge, Jose | Journal of Money, Credit & Banking, September 2008 | Go to article overview

The Role of Interbank Markets in Monetary Policy: A Model with Rationing


Freixas, Xavier, Jorge, Jose, Journal of Money, Credit & Banking


THE AIM OF THIS PAPER is to understand how financial imperfections in the interbank market affect the monetary policy transmission mechanism and, more precisely, to explore whether the structure of the banking system has any effects beyond those of the classical money channel.

There are two basic empirical motivations for our work. On the one hand, Kashyap and Stein's (2000) result, showing that the impact of monetary policy on a bank's amount of lending is stronger for banks with less liquid balance sheets, establishes the existence of imperfections in the interbank market. Such a liquidity effect is a challenge to the theoretical modeling of monetary policy channels based on highly efficient interbank markets, an assumption justified by the large volumes of transactions and the particularly low spreads observed on these markets.

On the other hand, the failure of existing theories of monetary transmission to explain a number of empirical facts has also been a motivation for our work. Bernanke and Gertler (1995) document that empirical research has been unsuccessful in identifying a quantitatively important cost of capital effect on private spending, which has been labeled the magnitude effect, whereby the aggregate impact of monetary policy is deemed excessively large, given the small elasticity of firms investment with respect to their cost of capital.

In this paper we show that, once we allow for interbank market imperfections, not only can we justify the Kashyap and Stein (2000) liquidity effect, but a new framework of analysis opens up, allowing for a better understanding of the magnitude effect.

The interbank market allows banks to cope with liquidity shocks by borrowing and lending from their peers, a function that, as it is assumed in this paper, the access to (inelastically supplied) deposits cannot fulfill. Our paper uncovers the important role of the interbank market in an asymmetric information setup by establishing the link between the imperfect functioning of the interbank market and the existence of rationing of banks and, in a cascading effect, of firms in the credit market. Our modeling of this effect allows us to establish that the relevance of imperfections in the interbank market for monetary policy depends on: (i) the dependence of firms on bank finance, (ii) the extent of relationship lending, in the sense of firms having access to funds through a unique bank, and (iii) the heterogeneity of banks' liquidity positions, resulting from Treasury securities (T-Bills) holdings resulting from past decisions and liquidity shocks originated in additional funding for existing projects.

The existence of credit rationing is of interest in our context because, traditionally, the theory of credit rationing has been developed in a borrower-lender framework, better suited to the theory of banking than to the analysis of the transmission mechanism of monetary policy. In this paper we argue that credit rationing might also be an important part of the transmission mechanism. Introducing interbank market imperfections in the analysis of monetary policy seems a reasonable approach for two reasons. First, the interbank market is the first one to be exposed to the effects of monetary policy in the chain of effects that will generate the full impact of monetary policy. Second, it is worth considering an imperfect interbank market because the Kashyap and Stein (2000) liquidity effect forces us to reconsider its supposedly perfect functioning and questions its purely passive role.

In order to analyze rigorously the effects of interbank markets imperfections on monetary transmission, we compare the transmission mechanism under two different scenarios: of symmetric and asymmetric information in the interbank market. The main lesson is that under asymmetric information, the interbank market is unable to efficiently channel liquidity to solvent illiquid banks, and as a consequence, there is quantity rationing in the bank loan market. …

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