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Precautionary hoarding of liquidity and inter-bank markets: Evidence from the sub-prime crisis

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  • Acharya, Viral V
  • Merrouche, Ouarda

Abstract

We study the liquidity demand of large settlement (first-tier) banks in the UK and its effect on the Sterling Money Markets before and during the sub-prime crisis of 2007-08. Liquidity holdings of large settlement banks experienced on average a 30% increase in the period immediately following 9th August, 2007, the day when money markets froze, igniting the crisis. In the UK, unlike in the US until October 2008, the remuneration of reserves accounts provides strong incentives for banks to park liquidity at the central bank rather than lend in the market. We show that following this structural break, settlement bank liquidity had a precautionary nature in that it rose on calendar days with a large amount of payment activity and for banks with greater credit risk. We establish that the liquidity demand by settlement banks caused overnight inter-bank rates to rise and volumes to decline, an effect virtually absent in the pre-crisis period. This liquidity effect on inter-bank rates occurred in both unsecured borrowing as well as borrowing secured by UK government bonds. Further, using bilateral data we show that the effect was more strongly linked to lender risk than to borrower risk.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8859.

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Date of creation: Feb 2012
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Handle: RePEc:cpr:ceprdp:8859

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Keywords: cash; contagion; counterparty risk; funding risk; money markets; rollover risk; systemic risk;

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  1. Viral V. Acharya & Denis Gromb & Tanju Yorulmazer, 2012. "Imperfect Competition in the Interbank Market for Liquidity as a Rationale for Central Banking," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(2), pages 184-217, April.
  2. Olivier Armantier & Eric Ghysels & Asani Sarkar & Jeffrey Shrader, 2011. "Stigma in financial markets: evidence from liquidity auctions and discount window borrowing during the crisis," Staff Reports 483, Federal Reserve Bank of New York.
  3. Viral V. Acharya & Philipp Schnabl & Gustavo Suarez, 2010. "Securitization without risk transfer," NBER Working Papers 15730, National Bureau of Economic Research, Inc.
  4. Fecht, Falko & Nyborg, Kjell G. & Rocholl, Jörg, 2008. "The price of liquidity: bank characteristics and market conditions," Discussion Paper Series 1: Economic Studies 2008,30, Deutsche Bundesbank, Research Centre.
  5. Bindseil, Ulrich & Nyborg, Kjell G & Strebulaev, Ilya, 2004. "Bidding and Performance in Repo Auctions: Evidence from ECB Open Market Operations," CEPR Discussion Papers 4367, C.E.P.R. Discussion Papers.
  6. Adam Ashcraft & James Mcandrews & David Skeie, 2011. "Precautionary Reserves and the Interbank Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 311-348, October.
  7. Acharya, Viral V. & Skeie, David, 2011. "A model of liquidity hoarding and term premia in inter-bank markets," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 436-447.
  8. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed not Frozen: The Fed Funds Market in the Financial Crisis," NBER Working Papers 15806, National Bureau of Economic Research, Inc.
  9. Gara Afonso & Anna Kovner & Antoinette Schoar, 2010. "Stressed, not frozen: the Federal Funds market in the financial crisis," Staff Reports 437, Federal Reserve Bank of New York.
  10. Ulrich Bindseil & Kjell G. Nyborg & Ilya A. Strebulaev, 2009. "Repo Auctions and the Market for Liquidity," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(7), pages 1391-1421, October.
  11. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2011. "Crisis Resolution and Bank Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2166-2205.
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