DP8705 A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets
|Author(s):||Viral V Acharya, David Skeie|
|Publication Date:||December 2011|
|Keyword(s):||bank liquidity, bank loans, debt, financial leverage, interbank market, risk management|
|JEL(s):||E43, G01, G21|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=8705|
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.