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Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk

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  • Heider, F.
  • Hoerova, M.
  • Holthausen, C.

    (Tilburg University, Center for Economic Research)

Abstract

We study the functioning and possible breakdown of the interbank market due to asymmetric information about counterparty risk. We allow for privately observed shocks to the distribution of asset risk across banks after the initial portfolio of liquid and illiquid investments is chosen. Our model generates sev- eral interbank market regimes: 1) low interest rate spread and full participation; 2) elevated spread and adverse selection; and 3) liquidity hoarding leading to a market breakdown. The regimes are in line with observed developments in the interbank market before and during the 2007-09 financial crisis. We use the model to examine various policy responses.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2009-40 S.

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Date of creation: 2009
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Handle: RePEc:dgr:kubcen:200940s

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