Liquidity crunch in the interbank market: is it credit or liquidity risk, or both?

Angelo Baglioni

No ief0091, DISCE - Quaderni dell'Istituto di Economia e Finanza from Università Cattolica del Sacro Cuore, Dipartimenti e Istituti di Scienze Economiche (DISCE)

Abstract: The interplay between liquidity and credit risks in the interbank market is analyzed. Banks are hit by idiosyncratic random liquidity shocks. The market may also be hit by a bad news at a future date, implying the insolvency of some participants and creating a lemon problem; this may end up with a gridlock of the interbank market at that date. Anticipating such possible contingency, banks currently long of liquidity ask a liquidity premium for lending beyond a short maturity, as a compensation for the risk of being short of liquidity later and being forced to liquidate some illiquid assets. Then banks currently short of liquidity may prefer to borrow short term. The model is able to explain some stylized facts of the 2007- 2009 liquidity crunch affecting the money market at the international level: (i) high spreads between interest rates at different maturities; (ii) "flight to overnight" in traded volumes; (iii) ineffectiveness of open market operations, leading the central banks to introduce some relevant innovations into their operational framework.

Keywords: Global financial crisis; Money market; Liquidity; Central banking. (search for similar items in EconPapers)
JEL-codes: E43 E50 G01 G21 (search for similar items in EconPapers)
Pages: 30
Date: 2009-11
New Economics Papers: this item is included in nep-ban, nep-mon and nep-mst
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Citations: View citations in EconPapers (6)

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Related works:
Journal Article: Liquidity Crunch in the Interbank Market: Is it Credit or Liquidity Risk, or Both? (2012)
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