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

59 Pages Posted: 5 Apr 2010

See all articles by Florian Heider

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: March 2010

Abstract

We study the functioning and possible breakdown of the interbank market in the presence of counterparty risk. We allow banks to have private information about the risk of their assets. We show how banks' asset risk affects funding liquidity in the interbank market. Several interbank market regimes can arise: i) normal state with low interest rates; ii) turmoil state with adverse selection and elevated rates; and iii) market breakdown with liquidity hoarding. We provide an explanation for observed developments in the interbank market before and during the 2007-09 financial crisis (dramatic increases of unsecured rates and excess reserves banks hold, as well as the inability of massive liquidity injections by central banks to restore interbank activity). We use the model to discuss various policy responses.

Keywords: Asymmetric information, Counterparty risk, Financial crisis, Interbank market, Liquidity

JEL Classification: D82, G01, G21

Suggested Citation

Heider, Florian and Hoerova, Marie and Holthausen, Cornelia, Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk (March 2010). CEPR Discussion Paper No. DP7762. Available at SSRN: https://ssrn.com/abstract=1583260

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 )

London
United Kingdom

Marie Hoerova

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
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)

London
United Kingdom

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