ILLIQUIDITY COMPONENT OF CREDIT RISK – THE 2015 LAWRENCE R. KLEIN LECTURE

Stephen Morris and Hyun Song Shin

International Economic Review, 2016, vol. 57, issue 4, 1135-1148

Abstract: We provide a theoretical decomposition of bank credit risk into insolvency risk and illiquidity risk, defining illiquidity risk to be the counterfactual probability of failure due to a run when the bank would have survived in the absence of a run. We show that illiquidity risk is (i) decreasing in the “liquidity ratio”—the ratio of realizable cash on the balance sheet to short‐term liabilities; (ii) decreasing in the excess return of debt; and (iii) increasing in the solvency uncertainty—a measure of the variance of the asset portfolio.

Date: 2016
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