Effects of Central Bank Intervention on the Interbank Market During the Subprime Crisis

Abstract

We explore whether central bank intervention improves liquidity in the interbank market during the current subprime crisis with unique trade and quote data from the e-MID, the only regulated electronic interbank market in the world. Central bank intervention consistently creates greater uncertainty in the interbank market. Prior to the crisis, the cover-to-bid ratio effectively conveys good and bad news from the central bank, but this link is broken during the crisis, suggesting that standard (and special) interventions that do not specifically target interbank asymmetric information fail to improve market liquidity. Our results suggest that the central bank should release stress tests for individual banks, provide interbank loan guarantees, or engage in direct asset purchases rather than simply providing more capital when counterparty risk poses systemic risk to the interbank market. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.