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

Abstract:     
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. We document that liquidity holdings of the large settlement banks in the UK 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 this liquidity demand by settlement banks caused overnight inter-bank rates to rise, in both secured and unsecured markets, an effect virtually absent in the pre-crisis period. This rise in borrowing rates was experienced by all settlement banks, regardless of counterparty risk, suggestive of an interest-rate contagion from weaker to stronger banks operating through the inter-bank markets.

Number of Pages in PDF File: 78

working papers series