Liquidity Crunch in the Interbank Market: Is it Credit or Liquidity Risk, or Both?

The interplay between liquidity and credit risks in the interbank market is analyzed. Banks are hit by idiosyncratic random liquidity shocks. The market may also be hit by bad news at a future date, implying the insolvency of some participants and creating a lemons problem; this may end up with a gridlock of the interbank market at that date. Anticipating such possible contingency, banks currently long of liquidity ask a liquidity premium for lending beyond a short maturity, as a compensation for the risk of being short of liquidity later and being forced to liquidate some illiquid assets. When such premium gets too high, banks currently short of liquidity prefer to borrow short term. The model is able to explain some stylized facts of the 2007-2009 liquidity crunch affecting the money market at the international level: (i) high spreads between interest rates at different maturities; (ii) "flight to overnight" in traded volumes; (iii) ineffectiveness of open market operations, leading the central banks to introduce some relevant innovations into their operational framework.