Speaker: Francesca Carapella, Federal Reserve Board - FRB
We provide a theory for the collapse in bank-to-bank trade experienced in the United States since the financial crisis and since the onset of a floor system for monetary policy. Our theory incorporates a key feature of interbank markets: credit is unsecured. This requires borrowing banks to be willing to repay their loans rather than forced to do so. When the punishment for failing to repay loans is permanent exclusion from interbank markets, if interest rates are too low the opportunity cost of holding money is too low, and so is the punishment for defaulting on loans. Hence borrowing banks have no incentive to repay their loans, the endogenous borrowing limit is zero and bank-to-bank lending collapses, despite banks would want to borrow. We propose a framework to conduct monetary policy that uniquely implements an equilibrium with an active interbank market, and provide conditions for it to be welfare improving over the equilibrium with no bank-to-bank trade under a floor system. Importantly, this framework does not rely on the concepts of abundant or ample reserve regimes, which dominated policy discussions as monetary policy normalization was taking place. Moreover, versions of this framework have been adopted by some central banks.