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

Abstract

We study the liquidity demand of large settlement banks in the UK and its eect on the Sterling Money Markets before and during the sub-prime crisis of 2007- 08. Liquidity holdings of large settlement banks experienced on average a 30% increase in the period immediately following 9th August, 2007, the day when money markets froze, igniting the crisis. Following this structural break, settlement bank liquidity had a precautionary nature in that it rose on calendar days with a large amount of payment activity and for banks with greater credit risk. We establish that the liquidity demand by settlement banks caused overnight inter-bank rates to rise, an eect virtually absent in the pre-crisis period. This liquidity eect on inter-bank rates occurred in both unsecured borrowing as well as borrowing secured by UK government bonds. Further, the eect was more strongly linked to lender risk than to borrower risk.