Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk

By Florian Heider, Marie Hoerova, Cornelia Holthausen. Social Science Research Network, 2009

368 citations recorded by the source corpus.

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 discuss various policy responses. JEL classification: G01, G21, D82 Keywords: Financial crisis; Interbank market; Liquidity; Asymmetric information We thank Gaetano Antinol, Patrick Bolton, Charles Calomiris, Elena Carletti, Nuno Cassola, V.V. Chari, Doug Diamond, Mathias Drehmann, Philipp Hartmann, Antoine Martin, Enrico Perotti, Tano Santos, and seminar participants at Columbia, Wharton, the FRB Philadelphia, the FRB New York (Conference on Central Bank Liquidity Tools), Amsterdam Business School (Workshop on Incentive Compatible Regulation), the 2008 UniCredit Conference on Banking and Finance (Vienna), the 2nd Swiss Banking Conference (Hasliberg), the ESMT, Sveriges Riksbank and the European Central Bank for helpful comments. Marco Lo Duca provided excellent research assistance. The views expressed do not necessarily reect those of the European Central Bank or the Eurosystem. yAll authors are at the European Central Bank, Financial Research Division, Kaiserstrasse 29, D-60311 Frankfurt, email: rstname.lastname@ecb.int Neither the recent massive money injections, the coordinated lowering of interest rates nor the use of public funds to recapitalize banks have done much to restart interbank lending. This action did not solve the underlying problem preventing interbank lending: extreme information asymmetry. Financial Times, November 9, 2008

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/4ad1c46ce63b66c6a73a03af7bbd7c1cb5fdc7a1

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Citations in the corpus

The ECB Unconventional Monetary Policies: Have They Lowered Market Borrowing Costs for Banks and Governments? (2012, background): “Indeed, Heider et al. (2009) theoretical model shows that in case of high counterparty risk and informational asymmetry, the central bank liquidity injections result in liquidity hoarding and finally contribute to the greater distress of the money markets.”
Where the Risks Lie: A Survey on Systemic Risk (2017, neutral): “Heider, Hoerova, and Holthausen (2015) build a more complete model showing how asymmetric information can lead to several regimes on the interbank market, including a market breakdown, and compare their results with the events during the financial crisis.”
Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes (2011, background): “More systematically, He, Khang, and Krishnamurthy (2010) show that over the period they examine, even while hedge funds and broker-dealers (typically investment banks) were reducing their holding of (illiquid) securitized assets by approximately $800 billion, insured commercial banks were…”
The ECB and the Interbank Market (2012, neutral): “1 of Joyce et al. (2010) for an analysis of the UK experience; the underlying framework is described in Walsh (1982). 2 See Stiglitz and Weiss (1982).”
Do Interbank Customer Relationships Exist? And How Did They Function in the Crisis? Learning from Italy (2012, neutral): “3 See Dudley (2008); Cassola et al. (2008); Gynetelberg and Wooldridge (2008); Michaud and Upper (2008); Angelini et al. (2011); Taylor and Williams (2009); Heider et al. (2009); Porzio et al. (2009); Afonso et al. (2010).”
Self-Fulfilling Liquidity Dry-Ups (2014, positive): “…buffers by 30% (Acharya and Merrouche, 2009); from September 2008, there has been a dramatic increase in the excess reserves of European banks (Heider et al., 2010), and of US major deposit institutions (by a factor larger than 1835); and, last but not least, despite the huge surge in supply…”