Interbank markets under currency boards

Date of Completion

January 2007


Economics, General|Business Administration, Banking




This thesis analyzes interbank markets under currency boards in different aspects. The first chapter provides a detailed institutional structure of the interbank markets under currency boards. Due to the currency board environment in these countries central banks have limited ability to intervene in interbank market in order to respond to systemic fluctuations in the outstanding liquidity in the market. Details of the required reserves policy, forex transactions at the central bank, relevant regulations directly or indirectly related to the interbank market and available data are discussed. ^ The second chapter provides an empirical analysis of interbank markets under currency boards. Under such an environment, problematic endogeneity issues common to other monetary regimes do not arise. Using daily data from the inter bank markets in Bulgaria and Lithuania, we show that contrary to the existing literature, overnight interest rates tend to decrease towards the end of the reserve holding period. ^ In the third chapter empirical results are supported by a finite horizon heterogeneous agents model showing that interest rates tend to decrease in the case of excess aggregate reserves in the banking system. Results contrast with Quirós and Mendizábal (2006), who find that interest rates should be increasing regardless of the outstanding aggregate liquidity in the market. We also show that responsiveness of banks to interest rate changes diminishes as the end of reserve holding period approaches. Under certain circumstances this could lead to multiple equilibria with increasing or decreasing interest rates. ^ The consensus view is that central banks under currency boards do not have tools for active monetary policy. In the fourth chapter we analyze the foreign exchange fee as a monetary policy instrument that can be used by a central bank under a currency board. We develop a general equilibrium model showing that changes in this fee may have the same effects as a change in the monetary policy stance. Thus, central banks operating under the currency board are shown to have an avenue to implement active monetary policy. ^