Liquidity Risk and Funding Cost

Abstract

We propose and test a new channel that links funding liquidity risk and interest rates in short-term funding markets. Borrowers with high liquidity risk are willing to pay a markup to lock in their funding, independent of risk premiums demanded by lenders. We test the channel using unique trade-by-trade data and reveal systematic and persistent differences in borrowers' funding liquidity risk that lead to systematic and persistent heterogeneity in funding costs. Our results have important implications for financial stability, the transmission of monetary policy, and banks' asset and liability management.

Keywords: funding liquidity risk, short-term interest rates, risk premiums, funding costs, interbank market

JEL Classification: G12, G18, G21, E43, E52, D40