Abstract
Abstract We present a two-country model featuring risky lending and cross-border interbank market frictions. We find that (i) the strength of the financial accelerator, when applied to banks operating under uncertainty in an interbank market, will critically depend on the economic and financial structure of the economy; (ii) adverse shocks to the real economy can be the source of banking crisis, causing an increase in interbank funding costs, aggravating the initial shock; and (iii) asset purchases and central bank long-term refinancing operations can be effective substitutes for, or supplements to, conventional monetary policy.
Highlights
In the years following the global financial and the euro area sovereign debt crisis, the process of financial integration in the euro area moved into reverse as firms and households in the southern European periphery started to face much higher borrowing costs than their counterparts in the northern core
We show that (i) the strength of the financial accelerator, when applied to banks operating under uncertainty in an interbank market, will critically depend on the economic and financial structure of the economy; (ii) adverse shocks to the real economy can be the source of banking crises, causing an increase in the interbank funding costs, aggravating the initial shock; and (iii) asset purchase policies and central bank long-term refinancing operations can both be an effective substitute, or complement, to changes in the conventional monetary policy instrument
We find that providing long-term refinancing operations (LTROs) to banks increases the effectiveness of monetary policy per unit of stimulus – that is, LTROs empower conventional monetary policy
Summary
In the years following the global financial and the euro area sovereign debt crisis, the process of financial integration in the euro area moved into reverse as firms and households in the southern European periphery started to face much higher borrowing costs than their counterparts in the northern core. We use our model to answer three important questions: (1) how is the transmission of monetary policy in a currency union affected when financing conditions in the interbank market depend on the quality of banks’ balance sheets; (2) how do asymmetric shocks to the value of assets propagate through a currency union when savings banks differentiate between domestic and foreign borrowers in the interbank market; and (3) how effective are some of the measures central banks have taken in the recent past to address funding bottlenecks in the interbank market?.
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