Report

A model of liquidity hoarding and term premia in inter-bank markets

Abstract: Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank loans, reflected in the one-month and three-month Libor. We explain such stress by modeling leveraged banks? precautionary demand for liquidity. Asset shocks impair a bank?s ability to roll over debt because of agency problems associated with high leverage. In turn, banks hoard liquidity and decrease term lending as their rollover risk increases over the term of the loan. High levels of short-term leverage and illiquidity of assets lead to low volumes and high rates for term borrowing. In extremis, inter-bank markets can completely freeze.

Keywords: Interbank market; Bank liquidity; Financial leverage; Risk management; Debt; Bank loans;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2011

Number: 498