Banks, Liquidity Management, and Monetary Policy

We develop a tractable model of banks' liquidity management with an over-the-counter interbank market to study the credit channel of monetary policy. Deposits circulate randomly across banks and must be settled with reserves. We show how monetary policy affects the banking system by altering the trade-off between profiting from lending and incurring greater liquidity risk. We present two applications of the theory, one involving the connection between the implementation of monetary policy and the pass-through to lending rates, and another considering a quantitative decomposition behind the collapse in bank lending during the 2008 financial crisis. Our analysis underscores the importance of liquidity frictions and the functioning of interbank markets for the conduct of monetary policy.

Automated summary

We have developed a tractable model to study the credit channel of monetary policy, which includes an over-the-counter interbank market for banks' liquidity management. Our research shows how monetary policy affects the banking system by changing the trade-off between profiting from lending and facing greater liquidity risk. We present two applications, one examining the connection between the implementation of monetary policy and the pass-through to lending rates, and another analyzing a quantitative decomposition of the collapse in bank lending during the 2008 financial crisis. Our analysis highlights the importance of liquidity frictions and the functioning of interbank markets for the conduct of monetary policy.