Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking

We study the interbank lending and asset sales markets in which banks with surplus liquidity have market power, frictions arise in lending due to moral hazard, and assets are bank-specific. Illiquid banks have weak outside options that allow surplus banks to ration lending, resulting in inefficient asset sales. A central bank can ameliorate this inefficiency by standing ready to fund illiquid banks, provided it is better informed than outside markets, or prepared to extend loss making loans. This rationale for central banking finds support in episodes that precede the modern central-banking era and informs debates on the supervisory and lender-of-last-resort roles of central banks