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Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis

  • Viral V. Acharya
  • Ouarda Merrouche

We study the liquidity demand of large settlement 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. 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 more so for weaker banks. We establish that the liquidity demand by settlement banks caused overnight inter-bank rates to rise, 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, the effect was experienced by all settlement banks, regardless of their credit risk, suggestive of an interest-rate contagion from weaker to stronger banks operating through the inter-bank markets.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16395.

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Date of creation: Sep 2010
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Publication status: published as Viral V. Acharya & Ouarda Merrouche, 2013. "Precautionary Hoarding of Liquidity and Interbank Markets: Evidence from the Subprime Crisis," Review of Finance, European Finance Association, vol. 17(1), pages 107-160.
Handle: RePEc:nbr:nberwo:16395
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