Regional Liquidity Shocks, Financial Markets, and Central Bank Policy

Abstract

Financial markets and financial intermediation may be competing mechanisms in the provision of liquidity insurance and their co-existence may adversely impact risk-sharing. The question studied here is what is the optimal central bank policy when there is private information about liquidity shocks and alternative insurance mechanisms. Regions are subject to idiosyncratic liquidity demand shocks and households are subject to liquidity preference shocks, where both types of shocks are private information. In the absence of central bank intervention, competitive equilibria with interbank lending and financial intermediation are inefficient relative to the first-best, as are competitive equilibria when financial intermediation, interbank and financial markets co-exist, often resulting in over-investment in the long-term asset. The heterogeneous regions share a common central bank, which can implement welfare-improving policies by acting as a mechanism designer. Constrained competitive equilibria can support the first-best allocation when the central bank uses two policies: (i) a simple portfolio restriction in the form of a liquidity floor, creating a wedge between the endogenous marginal rate of transformation and the interbank lending rate; (ii) allowing intermediary liabilities to be negotiable, or to serve as collateral in loans or repurchase agreements. Both policies play a critical role in restoring efficiency. Although the central bank can prevent trading of intermediary liabilities in local financial markets, it is not optimal to do so. The issues studied here might arise, for example, in a banking union with a common central bank or a large country with regional liquidity shocks.