The financial market turmoil that has been under way since the Summer of 2007 hit the core of the global financial system, the inter-bank market for liquidity. This has manifested itself through episodes of widening spreads on inter-bank interest rates (vs. policy rates), together with evidence of plummeting volumes in inter-bank lending transactions. As turmoil turned into a full blown crisis in the Fall of 2008, inter-bank transactions were widely reported as frozen, as bid-offer spreads widened dramatically, and interest rates peaked on term borrowing beyond overnight transactions.
A significant part of this phenomenon has been ascribed to a reassessment of credit risk involved in dealing with bank counterparties. Yet a large share of the premium that has emerged on inter-bank rates has been attributed to “liquidity risk”. To be sure, liquidity needs on behalf of banks were to some extent related to concerns by financial institutions over their own balance sheets dynamics in the face of credit losses. More generally, banks certainly needed liquidity as they prepared for: (i) firms calls on contingent credit lines; (ii) re-intermediation of investments that had previously been funded off-balance sheet ; (iii) possible merger and acquisition opportunities.
This paper does not endeavour to account for all the features of the recent crisis, be it hard evidence or casual stories about the motivations of market players. However, it argues that a proper modelling of the collapse in the market for liquidity involves a close look at incentives to provision liquidity and moral hazard mechanisms in the inter-bank market. In addition, it makes sense to do so in a framework where banks can actually fail and default on their borrowing.
These assumptions are both strongly vindicated by salient features of the recent crisis. Many observers have argued that securitization may have provided the wrong incentives regarding the monitoring of underlying asset quality, in a clear-cut case of moral hazard. In addition, recent developments have shown that bank failures scenarios are only too realistic.