Why Do Banks Default When Asset Quality Is High?

Short-term financing, e.g., asset-backed commercial paper (ABCP) or repurchase agreements (repo), was prevalent prior to the 2007-2008 financial crises. Banks funded by short-term debts, however, are exposed to rollover risk as the banks are unable to raise sufficient funds to finance their long-term assets. Under such circumstance, banks’ equity holders need to absorb the rollover loss. Both deteriorating collateral assets’ fundamentals and market illiquidity are important drivers of the rollover risk. In this paper, we develop a structural default model based on Leland (1994), in which default is an endogenously determined decision made by equity holders, to analyze the joint effect of market liquidity and interest rate sensitive fundamentals of collateral assets’ on the survival times of banks relying on day-to-day short-term finance. The proposed model provides an explanation of the empirical observed phenomenon that banks default even when the quality of their fundamentals is still high.