Discussion Paper Details

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Title: A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets

Author(s): Viral V. Acharya and David Skeie

Publication Date: December 2011

Keyword(s): bank liquidity, bank loans, debt, financial leverage, interbank market and risk management

Programme Area(s): Financial Economics

Abstract: Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank transactions, such as in one-month and three-month LIBOR markets. We provide an explanation of such stress in term lending by modelling leveraged banks? precautionary demand for liquidity. When adverse asset shocks materialize, a bank?s ability to roll over debt is impaired because of agency problems associated with high leverage. In turn, a bank?s propensity to hoard liquidity is increasing, or conversely its willingness to provide term lending is decreasing, in its rollover risk over the term of the loan. High levels of short-term leverage and illiquidity of assets can thus lead to low volumes and high rates for term borrowing, even for banks with profitable lending opportunities. In extremis, there can be a complete freeze in inter-bank markets.

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Bibliographic Reference

Acharya, V and Skeie, D. 2011. 'A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets'. London, Centre for Economic Policy Research.