We propose a new channel that outlines how liquidity risk impacts interest rates in short term funding markets, the liquidity risk channel. We show that borrowers have a higher willingness to pay for liquidity if they experience liquidity shocks that need to be balanced urgently. High liquidity risk banks experience more liquidity shocks, are more likely to become constrained, and thus pay higher interest rates for short term funding. We test, and quantify this liquidity risk channel, revealing systematic heterogeneity across banks’ liquidity risk, their willingness to pay for immediate access to liquidity, and hence their funding cost. This heterogeneity is persistent over more than ten years, suggesting that the channel is related to liquidity management in general and not only arises during crisis times.
Three major identification challenges arise: First, we must isolate funding transactions from transactions with other intentions, such as market making, speculation, arbitrage trading, or sourcing a specific security. Second, we must construct a measure for the idiosyncratic liquidity risk of borrowers. Finally, we must isolate the markup a borrower is willing to pay due to being liquidity constrained from the premiums demanded by lenders. We overcome these challenges by exploiting the institutional design of the European interbank funding market, including anonymous electronic trading and central clearing.
Our results are important for at least three reasons. First, the liquidity risk channel provides an explanation for how liquidity risk can lead to liquidity constraints that affect interest rates in short-term funding markets. Second, it contributes to explain the systematic and persistent heterogeneity in funding costs. Third, the liquidity risk channel becomes even more important in light of the transition to real-time payment systems. The need to settle payments immediately creates additional challenges for the liquidity management of banks and could potentially be a new source of financial instability. Thus, understanding the origins and dynamics of funding constraints is crucial for regulators that aim to maintain financial stability and curtail the liquidity risk of banks (e.g., Basel III and the Dodd-Frank Act).
Panel (a) of Figure 1 presents for each borrower the average daily overnight repo rate paid in excess of the volume-weighted market average rate. In other words, it shows the average additional borrowing costs paid by each bank compared to the market average. Banks on the x-axis are ordered according to their performance. The filled black circles denote statistical significance at the 5% level. One outlier at 8.4 basis points is omitted. Panel (b) depicts the time variation of the banks with a significant positive and negative average excess rate, that is, those above and below the solid vertical line in Panel (a).