I am happy to share with you our new working paper “Liquidity Risk and Funding Cost”, available at https://ssrn.com/abstract=3391129.
The paper is joint work with Angelo Ranaldo and Jan Wrampelmeyer. We propose and test a new channel that outlines how funding liquidity risk affects interest rates in short-term funding markets – the funding liquidity risk channel. Unlike existing theories on interest rate spreads, the funding liquidity risk channel does not work through premiums demanded by lenders. In extant literature, interest rate or yield spreads are usually attributed to premiums required by lenders as compensation for default risk and market illiquidity. If borrowers are more likely to default or if markets are illiquid, lenders demand higher rates of return. In the funding liquidity risk channel, we turn this rationale upside down. Exploiting the unique market design of the euro interbank market, we show that borrowers themselves are willing to pay higher rates to lock in their funding if they are exposed to liquidity shocks.
The borrower markup is essential for understanding yield spreads in fixed-income markets. We show that banks differ systematically in their liquidity risk, which leads to systematic differences in their funding cost (see figure).
Our results have important implications for policymakers, (central) banks, and academia. Interpreting interest rate spreads without considering funding liquidity can be misleading. In addition, heterogeneity in short-term funding rates can undermine the efficient allocation of liquidity and the pass-through of monetary policy.
I am looking forward to presenting the paper at this year’s EFA Meeting in Carcavelos, Portugal.