A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets
Viral V. Acharya
New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance
David R. Skeie
Federal Reserve Bank of New York
CEPR Discussion Paper No. DP8705
Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank transactions, such as in one-month and three-month LIBOR markets. We provide an explanation of such stress in term lending by modelling leveraged banks precautionary demand for liquidity. When adverse asset shocks materialize, a banks ability to roll over debt is impaired because of agency problems associated with high leverage. In turn, a banks propensity to hoard liquidity is increasing, or conversely its willingness to provide term lending is decreasing, in its rollover risk over the term of the loan. High levels of short-term leverage and illiquidity of assets can thus lead to low volumes and high rates for term borrowing, even for banks with profitable lending opportunities. In extremis, there can be a complete freeze in inter-bank markets.
Number of Pages in PDF File: 37
Keywords: bank liquidity, bank loans, debt, financial leverage, interbank market, risk management
JEL Classification: E43, G01, G21working papers series
Date posted: December 22, 2011
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