Banks, Liquidity Management and Monetary Policy

We develop a new framework to study the implementation of monetary policy through the banking system. Banks make loans by issuing deposits. Loans are illiquid and, therefore, cannot be used to settle transfers of deposits. Instead, banks use central bank reserves for settlements but they may end short of reserves. This possibility induces a tradeoff between profiting from more loans against more liquidity risk exposure. Monetary policy alters this tradeoff and consequently affects aggregate credit and interest rates. In turn, banks also react to shocks that alter the distribution of payments, induce bank equity losses, increase capital requirements, and cause contractions in the loans demand. We study how the effectiveness of monetary policy varies with these shocks. We calibrate our model to study, quantitatively, why have banks increased their liquidity holdings but not increased lending despite the policy efforts of recent years.