New Micro-foundations for Macroeconomics
"Liquidity Hoarding, Network Externalities, and Interbank Market Collapse"
Sujit Kapadia (Bank of England)
Friday 10 July, 12.15 - 13.00
Abstract
The interbank market collapse has been a central feature of the global financial crisis. From August 2007, banks stopped lending to each other at all but the shortest maturities triggering a funding drought across the entire global financial system. Taking a network approach, our paper argues that such a breakdown can be explained by precautionary hoarding amongst some banks due to concerns about their own future liquidity needs and endogenous responses by banks to the liquidity hoarding of others. Critically, banks do not internalise the potential systemic consequences of their hoarding behaviour on the broader network. Though rare, illiquidity cascades - which lead to the breakdown of the entire interbank network - may thus develop suddenly once a critical proportion of banks engage in hoarding. Our findings speak to the potential role that tougher liquidity requirements for systemically important institutions could play in averting contagion through funding markets.