Ebook Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk
Interbank markets play a key role in banks liquidity management and the transmission of monetary policy. They provide benchmark rates for the pricing of fixed income securities throughout the economy (e.g. LIBOR). In normal times, interbank markets are among the most liquid in the financial sector. Since August 2007, however, the functioning of interbank markets has become severely impaired around the world. As the financial crisis deepened in September 2008, liquidity in the interbank market has further dried up as banks preferred hoarding cash instead of lending it out even at short maturities. Central banks massive injections of liquidity did little to restart interbank lending. The failure of the interbank market to redistribute liquidity has become a key feature of the 2007&09 crisis (see, for example, Allen and Carletti, 2008, and Brunnermeier, 2009).
Figure 1 illustrates the unprecedented extent of the turbulence. It plots the spread between the three&month unsecured rate and the overnight index swap in three monthsntime, a standard measure of interbank market tensions (red line), and the amounts of excess reserves banks hold with the European Central Bank (light and dark blue bars). A notable feature is the build up of tensions in the interbank market. Until August 9, 2007, the unsecured euro interbank market is characterized by a very low spread, around five basis points, and infinitesimal amounts of excess reserves with the European Central Bank (ECB). In normal times, banks prefer to lend out excess cash since the interest rate on excess reserves is punitive relative to rates available in interbank markets. The turmoil phase between August 9, 2007 and the last weekend of September 2008 is characterized by a significantly higher spread, yet excess reserves remain virtually nil. As of September 28, 2008, the spread increases even further to a maximum of 186 basis points. But the distinguishing feature of this crisis phase is a dramatic increase in excess reserves. Banks are hoarding liquidity. At the same time, the average daily volume in the overnight unsecured interbank market halved. A similar pattern of three distinct phases can be observed in the spread for the United States (Figure 2).
What caused the interbank market to seize up? Why has the market been dysfunctional for so long despite massive interventions by public authorities? What frictions can explain these developments and how do they relate to the broader roots of the financial crisis? And how do the policy responses that were discussed or implemented around the world hold up against these frictions?
This paper provides a model of how the risk of banks long&term assets can lead to the evaporation of liquidity in the unsecured interbank market. The key friction in the model is counterparty risk. Asymmetric information amplifies the friction. We use the model to understand the qualitative developments prior to and during the financial crisis, and to shed light on policy responses. We model banks as maturity transformers that face a trade&off between liquidity and return. Banks trade in the interbank market to smooth out idiosyncratic liquidity shocks. Lending banks face counterparty risk stemming from the risk of borrowing banks assets. Each bank knows the distribution of risk in the banking sector and is privately informed about the risk of its own assets but banks cannot observe the risk of their counterparties.
Various interbank market regimes arise depending on the level and distribution of counterparty risk. First, when the level and dispersion of risk are low, the unsecured interbank market functions smoothly despite counterparty risk and asymmetric information. The interest rate for unsecured loans is low and all banks manage their liquidity using the interbank market. Riskier banks exert an externality on safer banks as the latter subsidize the liquidity of the former. But the cost is small compared to the cost of obtaining liquidity outside the unsecured market. Second, for higher levels of risk there can be adverse selection in the interbank market. The externality on safer banks is so costly that they leave the unsecured market. Liquidity is still traded but the interest rate rises to reflect the presence of riskier banks. Third, the interbank market may break down when the dispersion of risk is high. Liquidity rich banks prefer to hoard liquidity instead of lending it out to an adverse selection of borrowers. Finally, it is possible that even riskier borrowers find the unsecured interest rate too high and prefer to obtain liquidity elsewhere. Moreover, when the dispersion of risk is high, multiple equilibria are possible and which regime occurs depends on self&fulfilling expectations.
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