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

53 Pages Posted: 22 Mar 2009 Last revised: 24 May 2016

Florian Heider

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Marie Hoerova

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Cornelia Holthausen

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: April 12, 2015

Abstract

We develop a model of interbank lending and borrowing with counterparty risk. The model has two key ingredients. First, liquidity in the banking sector is endogenous, which means that there is an opportunity cost of holding liquid assets. Second, banks are privately informed about the risk of their long-term assets, which can lead to adverse selection and high interest rates in the interbank market. We identify a novel form of a market break-down, which can lead to liquidity hoarding. It arises because adverse selection in the interbank market changes the opportunity cost of holding liquidity. We use the model to shed light on developments in interbank markets prior to and during the 2007-09 financial crisis, as well as the effectiveness of policy interventions aimed at restoring interbank market activity.

Keywords: Interbank market; Endogenous liquidity; Counterparty risk; Asymmetric information; Market break-down; Financial crisis

JEL Classification: G01, G21, D82

Suggested Citation

Heider, Florian and Hoerova, Marie and Holthausen, Cornelia, Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk (April 12, 2015). Journal of Financial Economics (JFE), 118, 336-354 (2015). Available at SSRN: https://ssrn.com/abstract=1362113

Florian Heider (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

HOME PAGE: http://https://sites.google.com/site/florianheider2/

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Marie Hoerova

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Cornelia Holthausen

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 6490 (Phone)
+49 69 1344 855 (Fax)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Paper statistics

Downloads
1,582
Rank
4,900
Abstract Views
5,947