Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis

Abstract

Using data on the behavior of large settlement banks in the UK and the Sterling Money Markets before and during the sub-prime crisis of 2007-08, we provide evidence of precautionary hoarding of liquidity and its e ect on inter-bank borrowing rates. Our evidence consists of three pieces. First, we document that liquidity holdings of the large settlement banks in the UK experienced on average a 30% increase in the period immediately following 9th August, 2007, the widely accepted date of money-market "freeze" during the sub-prime crisis. Second, we show that following this structural break, bank liquidity had a precautionary nature in that it rose on calendar days predicted to have a large amount of uctuations in payment and settlements activity and more so for banks that made larger losses during the crisis. Third, using the payment and settlements activity as an instrument, we establish a causal e ect of bank liquidity on overnight inter-bank rates, in both secured and unsecured markets, an e ect that is virtually absent in the period before the crisis. Importantly, precautionary hoardings by some settlement banks raised lending rates for all settlement banks, suggestive of a contagion-style systemic risk operating through inter-bank rates. Finally, variability in overnight inter-bank rates appears to have a ected rates and volumes in household as well as corporate lending.