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A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets

  • Acharya, Viral V
  • Skeie, David

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8705.

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Date of creation: Dec 2011
Date of revision:
Handle: RePEc:cpr:ceprdp:8705
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  1. Douglas W. Diamond, 1998. "Reputation Acquisition in Debt Markets," Levine's Working Paper Archive 602, David K. Levine.
  2. Viral V. Acharya & Douglas Gale & Tanju Yorulmazer, 2011. "Rollover Risk and Market Freezes," Journal of Finance, American Finance Association, vol. 66(4), pages 1177-1209, 08.
  3. Freixas, X. & Holthausen, C., 2001. "Interbank Market Integration under Asymmetric Information," Papers 74, Quebec a Montreal - Recherche en gestion.
  4. Freixas, X. & Martin, A. & Skeie, D., 2010. "Bank Liquidity, Interbank Markets, and Monetary Policy," Discussion Paper 2010-35S, Tilburg University, Center for Economic Research.
  5. Acharya, Viral V & Gromb, Denis & Yorulmazer, Tanju, 2008. "Imperfect Competition in the Inter-Bank Market for Liquidity as a Rationale for Central Banking," CEPR Discussion Papers 6984, C.E.P.R. Discussion Papers.
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  11. David R. Skeie, 2008. "Banking with nominal deposits and inside money," Staff Reports 242, Federal Reserve Bank of New York.
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  13. Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.
  14. Dennis Kuo & David R. Skeie & James Vickery & Thomas Youle, 2013. "Identifying term interbank loans from Fedwire payments data," Staff Reports 603, Federal Reserve Bank of New York.
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  28. James J. McAndrews & Asani Sarkar & Zhenyu Wang, 2008. "The effect of the Term Auction Facility on the London Inter-Bank Offered Rate," Staff Reports 335, Federal Reserve Bank of New York.
  29. John Taylor & John Williams, 2008. "Further Results on a Black Swan in the Money Market," Discussion Papers 07-046, Stanford Institute for Economic Policy Research.
  30. Gara Afonso & Anna Kovner & Antoinette Schoar, 2011. "Stressed, Not Frozen: The Federal Funds Market in the Financial Crisis," Journal of Finance, American Finance Association, vol. 66(4), pages 1109-1139, 08.
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