Abstract

A major lesson of the recent financial crisis is that the interbank lending market is crucial for banks facing large uncertainty regarding their liquidity needs. This paper studies the efficiency of the interbank lending market in allocating funds. We consider two diferent types of liquidity shocks leading to diferent implications for optimal policy by the central bank. We show that, when confronted with a distributional liquidity-shock crisis that causes a large disparity in the liquidity held among banks, the central bank should lower the interbank rate. This view implies that the traditional tenet prescribing the separation between prudential regulation and monetary policy should be abandoned. In addition, we show that, during an aggregate liquiditycrisis, central banks should manage the aggregate volume of liquidity. Two diferent instruments, interest rates andliquidityinjection, are therefore required to cope with the two diferent types of liquidity shocks. Finally, we show that failure to cut interest rates during a crisis erodes financial stability by increasing the risk of bank runs.