systemic risk and regulation.pptVIP

Interbank Market Liquidity and Central Bank Intervention Franklin Allen Elena Carletti University of Pennsylvania University of Frankfurt and CFS Douglas Gale New York University Bank of England 23-24 June, 2008 * Introduction Interbank markets are A very important part of the financial system Relatively little studied Central banks intervene heavily in these markets Most of the time they function well, but occasionally they appear not to (e.g., the freezes since August 2007) How do such markets work and what are the effects of central bank intervention? * Introduction (cont.) Many banks participate in the interbank markets Markets are competitive Many transactions involve government securities Either as asset sales Or as collateral in repos This suggests that market power and asymmetric information often may not be very important * Our approach Banks are subject to two types of liquidity risk Idiosyncratic Aggregate But they have difficulties in hedging these risks, particularly the idiosyncratic risk Interbank markets are incomplete in this sense Market allocations can be inefficient as a result * Our approach (cont.) Characterize the constrained efficient allocation Demonstrate how (incomplete) interbank markets lead to an inefficient allocation Excess price and consumption volatility Show that the central bank can implement the constrained efficient allocation by engaging in open market operations and fixing the interest rate * The model Three dates t = 0, 1, 2 A single good that can be used for consumption or investment at each date Banks are competitive, raise deposits paying c1 = d at t = 1 and c2 at t = 2, invest in risk free assets and trade on an interbank market Depositors: Measure is 1 Each has an initial endowment of 1 Utility function u(ct) for t = 1,2 * Depositors have consumption shocks with * Banks invest y in a short asset and 1 – y in a long asset t = 0 1 2 Short: 1