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Liquidity Crunch in the Interbank Market: Is it Credit or Liquidity Risk, or Both?

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  • Angelo Baglioni

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Abstract

The interplay between liquidity and credit risks in the interbank market is analyzed. Banks are hit by idiosyncratic random liquidity shocks. The market may also be hit by a bad news at a future date, implying the insolvency of some participants and creating a lemon problem; this may end up with a gridlock of the interbank market at that date. Anticipating such possible contingency, banks currently long of liquidity ask a liquidity premium for lending beyond a short maturity, as a compensation for the risk of being short of liquidity later and being forced to liquidate some illiquid assets. Then banks currently short of liquidity may prefer to borrow short term. The model is able to explain some stylized facts of the 2007- 2009 liquidity crunch affecting the money market at the international level: (i) high spreads between interest rates at different maturities; (ii) "flight to overnight" in traded volumes; (iii) ineffectiveness of open market operations, leading the central banks to introduce some relevant innovations into their operational framework.

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File URL: http://hdl.handle.net/10.1007/s10693-011-0110-2
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Bibliographic Info

Article provided by Springer in its journal Journal of Financial Services Research.

Volume (Year): 41 (2012)
Issue (Month): 1 (April)
Pages: 1-18

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Handle: RePEc:kap:jfsres:v:41:y:2012:i:1:p:1-18

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Web page: http://www.springerlink.com/link.asp?id=102934

Related research

Keywords: Global financial crisis; Money market; Liquidity; Central banking; G01; G21; E43; E50;

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Citations

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Cited by:
  1. Angelo Baglioni & Andrea Monticini, 2010. "Why does the Interest Rate Decline Over the Day? Evidence from the Liquidity Crisis," DEP - series of economic working papers 4/2010, University of Genoa, Research Doctorate in Public Economics.
  2. Giuseppe Mastromatteo, 2011. "The Debate on the Crisis: Recent Reappraisals of the Concept of Functional Finance," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0105, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
  3. Poskitt, Russell & Waller, Bradley, 2011. "Do liquidity or credit effects explain the behavior of the BKBM-LIBOR differential?," Pacific-Basin Finance Journal, Elsevier, vol. 19(2), pages 173-193, April.
  4. Sandro Brusco & Luca Colombo & Umberto Galmarini, 2010. "Local Governments Tax Autonomy, Lobbying, and Welfare," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0097, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).
  5. Giuseppe Mastromatteo, 2011. "H.P. Minsky And Policies To Countervail Crises," DISCE - Quaderni dell'Istituto di Economia e Finanza ief0102, Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE).

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