Interbank market friction-induced holdings of precautionary liquidity: implications for bank loan supply and monetary policy implementation

We analyze the impact of overnight interbank market frictions on bank loan supply when banks face idiosyncratic liquidity risk and discuss resulting implications for monetary policy implementation. Sufficiently pronounced interbank market frictions imply that banks hold positive or negative precautionary liquidity. Holding positive (negative) precautionary liquidity means that banks hold more (less) liquidity than they expect to need. As holding precautionary liquidity is costly, interbank market frictions negatively influence bank loan supply. However, by means of its standing facilities, the central bank not only offers an alternative to using the interbank market but also determines the costs of friction-induced holdings of positive or negative precautionary liquidity. Therefore, the facilities allow the central bank to influence banks’ expected liquidity costs, and thereby their loan supply, so that interbank market frictions need not be an impediment to monetary policy transmission