Precautionary hoarding of liquidity and inter-bank markets: Evidence from the sub-prime crisis

Viral Acharya and Ouarda Merrouche (ouarda.merrouche@eui.eu)

No 8859, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study the liquidity demand of large settlement (first-tier) banks in the UK and its effect on the Sterling Money Markets before and during the sub-prime crisis of 2007-08. Liquidity holdings of large settlement banks experienced on average a 30% increase in the period immediately following 9th August, 2007, the day when money markets froze, igniting the crisis. In the UK, unlike in the US until October 2008, the remuneration of reserves accounts provides strong incentives for banks to park liquidity at the central bank rather than lend in the market. We show that following this structural break, settlement bank liquidity had a precautionary nature in that it rose on calendar days with a large amount of payment activity and for banks with greater credit risk. We establish that the liquidity demand by settlement banks caused overnight inter-bank rates to rise and volumes to decline, an effect virtually absent in the pre-crisis period. This liquidity effect on inter-bank rates occurred in both unsecured borrowing as well as borrowing secured by UK government bonds. Further, using bilateral data we show that the effect was more strongly linked to lender risk than to borrower risk.

Keywords: Cash; Contagion; Systemic risk; Counterparty risk; Money markets; Funding risk; Rollover risk (search for similar items in EconPapers)
JEL-codes: E42 E58 G21 G28 (search for similar items in EconPapers)
Date: 2012-02
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (88)

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Related works:
Journal Article: Precautionary Hoarding of Liquidity and Interbank Markets: Evidence from the Subprime Crisis (2013)
Working Paper: Precautionary Hoarding of Liquidity and the Interbank Markets: Evidence from the Sub-Prime Crisis (2013)
Working Paper: Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis (2010)
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