Non-technical summary of the paper:
Unsecured interbank money market rates such as the Euribor increased strongly with the start of the …nancial market turbulences in August 2007. There is clear evidence that these rates reached levels that cannot be explained alone by higher counterparty credit risk, i.e. the credit risk of the lender in a money market transaction. To illustrate this, we use market based measures for credit risk, like the CDS spread, to extract the credit risk for Euribor panel banks and contrast these with the reported Euribor rates. Since August 2007, there is evidence of a large, persistent and time varying component of the Euribor-Eurepo spread that cannot not be attributable to the credit risk of the lender.
This paper presents a theoretical model which explains this component with reference to the funding liquidity risk of lenders in unsecured term money markets. To this end we model a three period interbank market in which banks optimally choose to lend liquidity surpluses short term (one period) or long term (two periods). The basic mechanism, leading to an elevated liquidity risk (or funding liquidity) premium in the interbank market is as follows. In a situation in which the likelihood of adverse liquidity shocks increases or the likelihood of a rating downgrade (or both), banks that o¤er long term funds are faced with an increased likelihood to have to seek re…nancing themselves in the interim period. All else equal, therefore, the price for long-term re…nancing goes up. This is because banks will internalise in the price they demand their own credit premia, which would re‡ect in the price they would have to pay would they have to re…nance in the interim period. This is what we call funding liquidity risk premium. Further, we extent the model in a number of ways, allowing for random allocation of bank types, a repo and a CDS market, in order to highlight the in‡uence of these markets on our measure of funding liquidity risk.