Working Paper: CEPR ID: DP8705
Authors: Viral V. Acharya; David Skeie
Abstract: Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank transactions, such as in one-month and three-month LIBOR markets. We provide an explanation of such stress in term lending by modelling leveraged banks? precautionary demand for liquidity. When adverse asset shocks materialize, a bank?s ability to roll over debt is impaired because of agency problems associated with high leverage. In turn, a bank?s propensity to hoard liquidity is increasing, or conversely its willingness to provide term lending is decreasing, in its rollover risk over the term of the loan. High levels of short-term leverage and illiquidity of assets can thus lead to low volumes and high rates for term borrowing, even for banks with profitable lending opportunities. In extremis, there can be a complete freeze in inter-bank markets.
Keywords: bank liquidity; bank loans; debt; financial leverage; interbank market; risk management
JEL Codes: E43; G01; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased rollover risk for banks (G21) | decreased willingness to provide term lending (G21) |
| high leverage and illiquidity (G19) | increased term borrowing rates (E43) |
| precautionary liquidity demands (E41) | reduced term interbank lending volumes (G21) |
| high leverage and illiquid assets (G19) | complete freeze in the interbank market (E44) |
| increased rollover risk (G32) | increased liquidity hoarding (E41) |