Interbank Lending, Credit-Risk Premia, and Collateral
ABSTRACT We study the functioning of secured and unsecured interbank markets in the presence of credit risk. The model generates empirical predictions that are in line with developments during the 2007–09 financial crisis. Interest rates decouple across secured and unsecured markets following an adverse shock to credit risk. The scarcity of underlying collateral may amplify the volatility of interest rates in secured markets. We use the model to discuss various policy responses to the crisis.
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ABSTRACT: author. Small sections of the text, not exceeding three paragraphs, can be used provided proper acknowledgement is given. The Rimini Centre for Economic Analysis (RCEA) was established in March 2007. RCEA is a private, nonprofit organization dedicated to independent research in Applied and Theoretical Economics and related fields. RCEA organizes seminars and workshops, sponsors a general interest journal The Review of Economic Analysis, and organizes a biennial conference: The Rimini Conference in Economics and Finance (RCEF) . The RCEA has a Canadian branch: The Rimini Centre for Economic Analysis in Canada (RCEA-Canada). Scientific work contributed by the RCEA Scholars is published in the RCEA Working Papers and Professional Report series. Abstract We investigate the relation between aggregate trading imbalances and interest rates in the Euro money market. We use data for OTC contracts as well as information from the major electronic trading platform in Europe to study the presence of cointegration between trading pressures and money market rates. We report strong evidence of a long-term linear relation between trading imbalances and liquidity prices for Euro interbank deposits.Applied Economics Letters 01/2012; · 0.23 Impact Factor
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ABSTRACT: The paper by Heider and Hoerova (2009) is ambitious. It studies the interaction between secured interbank lending, unsecured inter- bank lending, and banks' portfolio choices. It is motivated by a puz- zling empirical observation, namely the "decoupling of secured and unsecured lending rates" in the Great Financial Crisis of 2007-09. The observation made by Heider and Hoerova is that on August 9, 2007, not only did secured three-month interbank rates start to exhibit historically unprecedented discounts to unsecured rates, but the time-series behavior of both rates began to diverge as never before. Furthermore, the discount of secured interbank rates fluctuated more strongly in the United States than in the euro area. While the evidence consists of only two plots of time series, it is obvi- ous without any further econometric analysis that the phenomenon is there and is significant. The simple observation that unsecured lending became more expensive than secured lending in a period of financial turbulence is not surprising. Any model of lending will produce this result. What is puzzling is the decoupling of the time-series behavior. In order to address this puzzle, Heider and Hoerova propose a model of inter- bank borrowing that imbeds both types of interbank markets into a model of bank portfolio management under investment risk. This model exhibits a key feature of what seems to have occurred after August 2007: the dramatic change in the risk of bank portfolios has affected secured and unsecured interbank rates differently. While this result is derived in an essentially static model, it is plausible and contributes greatly to our understanding of the crisis.01/2009;
Interbank Lending, Credit Risk Premia and Collateral∗
Florian HeiderMarie Hoerova†
June 8, 2009
We study the functioning of secured and unsecured interbank markets in the pres-
ence of credit risk. We allow for safe collateral, e.g. government bonds, as well as risky
collateral, e.g. mortgage-backed securities, in secured interbank transactions. Acquir-
ing liquidity in the unsecured market is costly due to credit risk premia, while the
secured segment is subject to market risk. The model illustrates how tensions in the
unsecured market and the market secured by risky collateral affect repo rates in the
market secured by safe collateral. The volatility of repo rates is exacerbated by the
scarcity of high-quality collateral. The model generates empirical predictions that are
in line with developments during the 2007-2009 financial crisis. Interest rates decouple
across secured and unsecured markets as well as across different collateral classes. We
use the model to discuss various policy responses.
JEL classification: G01, G21, D82
Keywords: Financial crisis; Interbank market; Liquidity; Credit risk
∗We thank Rafael Repullo, and seminar participants at the European Central Bank for helpful comments.
Marco Lo Duca provided excellent research assistance. The views expressed do not necessarily reflect those
of the European Central Bank or the Eurosystem.
†The authors are at the European Central Bank, Financial Research Division, Kaiserstrasse 29, D-60311
Frankfurt, email: email@example.com
Interbank markets play a key role in the financial system. They are vital for banks’ liquid-
ity management and the transmission of monetary policy. The interest rate in the unse-
cured three-month interbank market acts as a benchmark for pricing fixed-income securities
throughout the economy. Secured, or repo, markets have been a fast-growing segment of
money markets: They have doubled in size since 2002 with gross amounts outstanding of
about $10 trillion in the United States and comparable amounts in the euro area just prior
to the start of the crisis in August 2007. Since repo transactions are backed by collateral
securities similar to those used in the central bank’s refinancing operations, repo markets
are a key tool for the implementation of monetary policy.
In normal times, interbank markets are among the most liquid in the financial sector.
Rates are usually stable across secured and unsecured segments, as well as across different
collateral classes. Since August 2007, however, the functioning of interbank markets has
become severely impaired around the world. The frictions in the interbank market have
become a key feature of the 2007-09 crisis (see, for example, Allen and Carletti, 2008, and
One striking manifestation of the frictions in the interbank market has been the decou-
pling of interest rates between secured and unsecured markets. Figure 1 shows the unsecured
and secured interbank market rates for the euro area since January 2007. Prior to the out-
break of the crisis in August 2007, the rates were closely tied together. Since August 2007,
they have moved in opposite directions with the unsecured rate increasing and the secured
rate decreasing. The decoupling further deepened after the Lehman bankruptcy, and to a
lesser extent, just prior to the sale of Bear Stearns.
A second, related important feature of the tensions in the interbank market has been the
difference in the severity of the disruptions in the United States and in Europe. Figure 2
shows rates in secured and unsecured interbank markets in the United States. As in Europe,
there is a decoupling of the rates at the start of the financial crisis and a further deepening
9th Aug. 07 Bear Stearns
sold to JP Morgan
126.96.36.199.1.5. 188.8.131.52.1.11. 184.108.40.206.220.127.116.11.18.104.22.168.22.214.171.124.1.5.
2007 2008 2009
3 months unsecured
3 months secured
Figure 1: Decoupling of secured and unsecured interbank rates in the EA
after the sale of Bear Stearns and the bankruptcy of Lehman. However, the decoupling and
the volatility of the rates is much stronger than in Europe.
Why then have secured and unsecured interbank interest rates decoupled? Why has the
US repo market experienced significantly more disruptions than the euro area market? What
underlying friction can explain these developments? And what policy responses are possible
to tackle the tensions in interbank markets?
To examine these questions, this paper provides a model of interbank markets with both
secured and unsecured lending in the presence of credit risk. We model the interbank market
in the spirit of Diamond and Dybvig (1983). Banks may need to realize cash quickly due
to demands of customers who draw on committed lines of credit or on their demandable
9th Aug. 07 Bear Stearns
sold to JP Morgan
1.1. 126.96.36.199.1.7. 188.8.131.52. 184.108.40.206.1.5. 220.127.116.11.18.104.22.168.22.214.171.124.
2007 2008 2009
3 months unsecured
3 months secured
Figure 2: Decoupling of secured and unsecured interbank rates in the US
deposits. Banks in need of liquidity can borrow from banks with a surplus of liquidity as
in Bhattacharya and Gale (1987) and Bhattacharya and Fulghieri (1994). Banks’ profitable
but illiquid assets are risky. Hence, banks may not be able to repay their interbank loan
giving rise to credit risk. To compensate lenders, borrowers have to pay a premium for funds
obtained in the unsecured interbank market.
In addition to the choice between the liquid (cash) and the illiquid asset (loans), banks
can invest in bonds. Bonds provide a long-run return but unlike the illiquid asset, they can
also be traded for liquidity in the short-term. We first consider the case of safe bonds, e.g.
government bonds. Since unsecured borrowing is costly due to credit risk, banks in need of
liquidity will sell bonds to reduce their borrowing needs. We assume that government bonds
are in fixed supply and that they are scarce enough not to crowd out the unsecured market.
Credit risk will affect the price of safe government bonds since banks with a liquidity surplus
must be willing to both buy the bonds offered and lend in the unsecured interbank market.
In equilibrium there must not be an arbitrage opportunity between secured and unsecured
We then introduce risky bonds, e.g. mortgage-backed securities. The realization of the
risky bond return becomes known when banks trade liquidity and safe bonds. Risky bond
returns lead to aggregate risk that spills over to the market for safe bonds. In consequence,
even the price of safe bonds will be volatile.
Our modeling assumptions are designed to reflect the insights from broad analyses of
the 2007-09 financial crisis. First, risk, and the accompanying fear of credit default, which
was created by the complexity of securitization, is at the heart of the financial crisis (see
Gorton, 2008, 2009). Second, illiquidity is a key factor contributing to the fragility of modern
financial systems (see, for example, Diamond and Rajan, 2008a, and Brunnermeier, 2009).
Hence, we employ the model of banking introduced by Diamond and Dybvig (1983) that
allows us to consider the tradeoff between liquidity and return in bank’s portfolio decisions.
A further advantage of this model is that it naturally creates a scope for interbank markets
(see Bhattacharya and Gale, 1987, and Bhattacharya and Fulghieri, 1994).1
This paper is part of the growing literature analyzing the ability of interbank market
to smooth out liquidity shocks. Our model builds on Freixas and Holthausen (2004) who
examine the scope for the integration of unsecured interbank markets when cross-country
information in noisy. They show that introducing secured interbank markets reduces interest
rates and improves conditions when unsecured markets are not integrated, however their
introduction may hinder the integration process.
The role of asymmetric information about credit risk as a factor behind tensions in
the unsecured interbank markets is emphasized in Heider, Hoerova and Holthausen (2009).
1An important complement to liquidity within the financial sector is the demand and supply of liquidity
within the real sector (see Holmstr¨ om and Tirole, 1998).