What do almost 20 years of micro data and two crises say about the relationship between central bank and interbank market liquidity? Evidence from Italy

Focus

This paper studies whether central bank liquidity provisions spur or inhibit interbank market liquidity exchanges, or do not affect them at all. In other words, it studies whether the relationship between central bank and interbank liquidity is complementary or substitutive, and whether the relationship changes in the event of interbank market impairments and massive central bank liquidity injections during global and sovereign crises.

Contribution

The analysis of the paper is relevant because having an adequate amount of liquidity in the system and adequate liquidity circulation throughout the banking system may both be crucial for the correct functioning of the economy. The paper reports findings based on 17 years of data on all the relationships of each bank operating in Italy vis-à-vis the ECB and every single (domestic and foreign) interbank counterparty.

Findings

The empirical results show that, both in normal times and in crises, the relationship between the central bank and interbank liquidity is complementary. Banks receiving central bank liquidity redistribute more to other banks. When central bank liquidity increases exponentially during a crisis, some healthy banks specialise in interbank lending. The complementarity helps to offset euro area fragmentation via domestic interbank relationships and to adjust the collateral and maturity profiles of banks' liquidity.

Abstract

This paper studies the mutual interplay between central bank (CB) liquidity provisions and interbank market (IM) liquidity exchanges, exploring whether the relationship changes in the event of IM impairments and massive CB liquidity injections during global and sovereign crises. The analysis uses a data set containing 17 years of monthly bank-by-bank and counterparty-by-counterparty data collated from 1998 to 2015 in Italy. The results show the existence of complementarity. Banks receiving CB liquidity redistribute more to other banks. When CB liquidity increases exponentially during crises, some healthy banks specialise in interbank lending. The complementarity helps to offset euro area fragmentation via domestic interbank relationships and to adjust the collateral and maturity profiles of banks' liquidity.

JEL codes: G21, E52, C30

Keywords: liquidity, financial and sovereign crises, central bank intervention, interbank