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Illiquidity Component of Credit Risk

Author

Listed:
  • Stephen Morris

    (Princeton University)

  • Hyun Song Shin

    (Bank for International Settlements; Princeton University)

Abstract

We provide a theoretical decomposition of bank credit risk into insolvency risk and illiquidity risk, defining illiquidity risk to be the counterfactual probability of failure due to a run when the bank would have survived in the absence of a run. We show that illiquidity risk is (i) decreasing in the "liquidity ratio"--the ratio of realizable cash on the balance sheet to short-term liabilities; (ii) decreasing in the excess return of debt; and (iii) increasing in the solvency uncertainty--a measure of the variance of the asset portfolio.

Suggested Citation

  • Stephen Morris & Hyun Song Shin, 2016. "Illiquidity Component of Credit Risk," Working Papers 081_2016, Princeton University, Department of Economics, Econometric Research Program..
  • Handle: RePEc:pri:metric:081_2016
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    References listed on IDEAS

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    1. Jean-Charles Rochet & Xavier Vives, 2004. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1116-1147, December.
    2. Morris, Stephen & Shin, Hyun Song, 1998. "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks," American Economic Review, American Economic Association, vol. 88(3), pages 587-597, June.
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    4. Postlewaite, Andrew & Vives, Xavier, 1987. "Bank Runs as an Equilibrium Phenomenon," Journal of Political Economy, University of Chicago Press, vol. 95(3), pages 485-491, June.
    5. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    6. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-781, December.
    7. Xavier Vives, 2014. "Strategic Complementarity, Fragility, and Regulation," Review of Financial Studies, Society for Financial Studies, vol. 27(12), pages 3547-3592.
    8. Morris, Stephen & Shin, Hyun Song & Yildiz, Muhamet, 2016. "Common belief foundations of global games," Journal of Economic Theory, Elsevier, vol. 163(C), pages 826-848.
    9. Itay Goldstein & Ady Pauzner, 2005. "Demand–Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, vol. 60(3), pages 1293-1327, June.
    10. Jimmy Shek & Ilhyock Shim & Hyun Song Shin, 2015. "Investor redemptions and fund manager sales of emerging market bonds: how are they related?," BIS Working Papers 509, Bank for International Settlements.
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    Citations

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    Cited by:

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    2. Javadi, Siamak & Mollagholamali, Mohsen, 2018. "Debt market illiquidity and correlated default risk," Finance Research Letters, Elsevier, vol. 26(C), pages 266-273.
    3. Naoto Okahara, 2019. "Banks’ disclosure of information and financial stability regulations," Evolutionary and Institutional Economics Review, Springer, vol. 16(1), pages 91-115, June.
    4. Schilling, Linda, 2017. "Optimal Forbearance of Bank Resolution," MPRA Paper 112409, University Library of Munich, Germany.
    5. Aikman, David & Haldane, Andrew & Hinterschweiger, Marc & Kapadia, Sujit, 2018. "Rethinking financial stability," Bank of England working papers 712, Bank of England.
    6. Rana Yassir Hussain Xuezhou Wen Rehan Sohail Butt Haroon Hussain Sikandar Ali Qalati Irfan Abbas, 2020. "Are Growth Led Financing Decisions Causing Insolvency in Listed Firms of Pakistan?," Zagreb International Review of Economics and Business, Faculty of Economics and Business, University of Zagreb, vol. 23(2), pages 89-115, November.
    7. Cont, Rama & Kotlicki, Artur & Valderrama, Laura, 2020. "Liquidity at risk: Joint stress testing of solvency and liquidity," Journal of Banking & Finance, Elsevier, vol. 118(C).
    8. Ahnert, Toni & Martinez-Miera, David, 2021. "Bank Runs, Bank Competition and Opacity," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242348, Verein für Socialpolitik / German Economic Association.
    9. Szkup, Michal, 2020. "Multiplier effect and comparative statics in global games of regime change," Theoretical Economics, Econometric Society, vol. 15(2), May.
    10. Choi, Dong Beom & Eisenbach, Thomas M. & Yorulmazer, Tanju, 2021. "Watering a lemon tree: Heterogeneous risk taking and monetary policy transmission," Journal of Financial Intermediation, Elsevier, vol. 47(C).
    11. Linda Schilling, 2018. "Optimal Forbearance of Bank Resolution," Working Papers 2018-15, Becker Friedman Institute for Research In Economics.
    12. Vo, Quynh-Anh, 2021. "Interactions of capital and liquidity requirements: a review of the literature," Bank of England working papers 916, Bank of England.
    13. Alexander Bechtel & Angelo Ranaldo & Jan Wrampelmeyer, 2019. "Liquidity Risk and Funding Cost," Working Papers on Finance 1903, University of St. Gallen, School of Finance, revised Aug 2020.

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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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