Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking

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Abstract
We consider liquidity transfers between banks through the inter-bank borrowing and asset sale markets when banks providing liquidity may have market power and assets may be bank-specific. We show that when the outside options of liquidity-affected banks are weak, surplus banks may strategically underprovide lending. Thereby inducing excessive and inefficient sales of bank-specific assets. A regulator such as a Central Bank can ameliorate this inefficiency by standing to lend to affected banks, provided it has greater information about banks (for example, through supervision) compared to the outside markets, or absent such information access, it is prepared to make some loss-making loans. The public provision of liquidity to banks, or its mere credibility, can thus improve the private allocation of liquidity among banks. This rationale for the existence of a Central Bank and has support in historical episodes preceding the modern era of Central Banking and has implications for recent debates concerning the supervisory and lender-of-last-resort roles of Central Banks.

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