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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
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Handle: RePEc:cpr:ceprdp:8705
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