LIQUIDITY, INTERBANK MARKET, AND THE SUPERVISORY ROLE OF THE CENTRAL BANK

Abstract

This paper provides an explanation for the supervisory role of the central bank in a monetary general equilibrium model of bank liquidity provision. Under incomplete information on the individual banks' liquidity needs, individual banks find it optimal to invest solely in bank loans holding no cash reserves, and rely on the interbank market for their withdrawal demands. Using the costly state verification approach under uncertainty in aggregate liquidity demands, the supervisory role of the central bank as a large intermediary arises as an incentive-compatible arrangement by which banks hold the correct level of cash reserves. First, it takes up a delegated monitoring role for the banking system. Second, it engages in discount-window lending at a penalty rate, where the discount margin covers exactly the monitoring cost incurred. Finally, under the central banking mechanism, currency premium no longer exists in the sense that currency is worth the same as deposits having an equal face value.