Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

Abstract

Euro-area sovereign bond and interbank interest rate spreads widened sharply in the 2007-2009 Global Financial Crisis and over the subsequent European Debt Crisis, greatly increasing financing costs. Such rate volatility could represent concerns over asset liquidity or issuer solvency. To precisely identify the relative contribution of these two effects in interest rate spreads, this paper uses a model-free measure of euro-area bond market liquidity. Liquidity accounts for 36% of the trough-to-peak sovereign spread widening during the Financial Crisis and 21% in the Debt Crisis, after controlling for default risk. Aggregate bond liquidity also explains a substantial portion of interbank spreads.

Keywords: market liquidity, interbank credit, liquidity risk, money markets, interest rates, financial crisis

JEL Classification: E44, G01, G12, G15