Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk

TLDR

The study examines how asymmetric counterparty risk information can cause interbank market breakdowns. The authors model privately observed shocks to banks’ asset‑risk distributions after initial liquidity choices and use the model to evaluate policy responses. The model produces three regimes—low spread with full participation, elevated spread with adverse selection, and liquidity hoarding causing market collapse—that match pre‑ and during‑2007‑09 crisis interbank market observations.

Abstract

We study the functioning and possible breakdown of the interbank market due to asymmetric information about counter party risk. We allow for privately observed shocks to the distribution of asset risk across banks after the initial portfolio of liquid and illiquid investments is chosen. Our model generates several interbank market regimes: 1) low interest rate spread and full participation; 2) elevated spread and adverse selection; and 3) liquidity hoarding leading to a market breakdown. The regimes are in line with observed developments in the interbank market before and during the 2007-09 financial crisis. We use the model to examine various policy responses.