A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets1

Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank loans, re‡ected in 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: Inter-bank lending; …nancial crisis; precautionary demand; rollover risk; LIBOR-OIS spread JEL Classi…cations: G21, G01, E43 1Corresponding author: David Skeie, Federal Reserve Bank of New York, 33 Liberty Street, NY, NY 10045, +1-212-720-5635, [email protected]. The views expressed in this paper are those of the authors and do not necessarily re‡ect the views of the Federal Reserve Bank of New York or the Federal Reserve System. We thank Sha Lu for excellent research assistance, Jamie McAndrews for valuable conversations, Hubero Ennis (discussant), Marvin Goodfriend (editor), and participants at the Workshop on Money Markets and Payments organized by the Federal Reserve Bank of New York (October 2010) and Carnegie-Rochester Conference on Public Policy (November 2010).