ESSAYS IN BANKING, LIQUIDITY AND SPECULATIVE ATTACKS ON FIXED EXCHANGED RATE REGIMES

This dissertation studies the technical behavior of the very short term money market by using the market microstructure approach. The special role of commercial banks as suppliers of liquidity in the financial system and their role in the foreign exchange market is at the center of this thesis.; The first essay analyzes the role of banks as market-makers in the market for liquidity. Banks are modeled as members of the Federal Reserve Wire Transfer Network (Fedwire) and the inter-bank Federal funds market, exchanging payments and maintaining lines of credit with each other. The model analyzes the exposure of the Federal Reserve as the operator of Fedwire and as the lender of last resort under the following scenarios: when inter-bank line-limits collapse; when the discount rate is reduced; when the variability of payments increases; when demand for reserves becomes more elastic; when the level of required reserves increases.; The second essay of this dissertation constructs an analytical model linking the use of a currency as a vehicle in foreign exchange transactions to the liquidity of the underlying payment system. A more liquid payment system allows cheaper access to intra-day credit by participating banks. In foreign exchange markets characterized by an asynchronization between the appearance of buyers and sellers of currencies, commercial banks provide immediacy in transactions through their access to payment systems. The cost for this provision of immediacy is measured as the bid-ask spread on the spot rate. It is shown to be linked directly to the liquidity of the underlying currencies' payment systems. The model demonstrates why bid-ask spreads in transactions with a currency having the most liquid payment system will be the lowest, making it cheaper to route cross-currency transactions through this currency.; The third essay in the first of this dissertation analyzes speculative attacks on fixed exchange rate regimes by looking at the behavior of banks, speculators and the central bank. Commercial banks write forward contracts for foreign exchange with speculators and with central banks, while central banks follow multiple objectives of exchange rate and interest rate management and have an aversion towards capital losses from foreign exchange intervention. Given expectations on the collapse of the exchange rate regime, and the degree of imprecision of information that agents have about central banks' non-borrowed reserves, the size of the attack and the volume and spreads in the forward markets is determined. The optimal intervention by central banks in the forward, spot and swap markets is derived. The model also explains the rationale for interest rate squeezes by central banks even though they are not high enough to deter speculation altogether. The failure of limitless credit lines between central banks (as in the European Exchange Rate Mechanism) to prevent the collapse of exchange rate regimes is also addressed in this essay.