Banks as Liquidity Providers in the Interbank Market

Abstract

Abstract The paper analyzes structural differences in banks' ability and willingness to supply liquidity in the interbank market given the existing prudential regulation using a partial equilibrium model. The results show differences in the Liquidity Coverage Ratio (LCR) effectiveness for two types of banks' business models. First, for the more traditional one (with structural liquidity surplus), the LCR measure enables banks to lend more in the interbank market (by letting them subtract possible cash inflows from the expected outflows under a liquidity stress scenario) but at the cost of allowing them to maintain lower default limits (thresholds on the maximum liquidity shock the banks can withstand without entering default). Second, banks with structural liquidity deficits that need other funding sources than retail deposits, like subsidiaries that receive finance from their parent banks, face tighter requirements on high-quality liquid assets, keep higher default limits and lend less in the interbank market. For this business model, often seen in emerging markets, including Romania, the LCR measure fosters banks' resilience to liquidity shocks. However, this LCR functionality might encourage them to overlook contagion risk from their parent and parent banks' economies, especially under favorable financial conditions. Prudential authorities should complement the LCR measure with other instruments (like liquidity stress test) that better assess banks' liquidity risk due to maturity mismatch. Banks' liquidity risk management can partially mitigate the differences in LCR effectiveness through precautionary holdings of additional liquidity buffers. Banks with higher risk aversion prefer maintaining a higher no-penalty limit (the maximum liquidity shock the bank can accommodate without a penalty fee) and an increased default threshold and are less willing to lend in the interbank market.