Staff Reports
A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets
May 2011 Number 498
JEL classification: G21, G01, E43

Authors: Viral V. Acharya and David Skeie

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.

Available only in PDF pdf  35 pages / 302 kb
For a published version of this report, see Viral V. Acharya and David Skeie, "A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets," Journal of Monetary Economics 58, no. 5 (July 2011): 436-47.
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