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Liquidity hoarding and interbank market spreads: the role of counterparty risk

  • Marie Hoerova

    (European Central Bank)

  • Cornelia Holthausen

    (European Central Bank)

  • Florian Heider

    (European Central Bank)

We study the functioning and possible breakdown of the interbank market due to asymmetric information about counterparty risk. We allow for privately observed shocks to the distribution of asset risk across banks after the initial portfolio of liquid and illiquid investments is chosen. Our model generates several interbank market regimes: 1) low interest rate spread and full participation; 2) elevated spread and adverse selection; and 3) liquidity hoarding leading to a market breakdown. The regimes are in line with observed developments in the interbank market before and during the 2007-09 nancial crisis. We use the model to examine various policy responses.

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Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 929.

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Date of creation: 2009
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Handle: RePEc:red:sed009:929
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