Why a Small Shock Can Turn into Interbank Market Freezing and Creditor Runs
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LIU, Xuewen
Review of Financial Studies , 2016, 29 (7), 1860 - 1910
Systematic creditor runs on financial institutions were a salient feature of the 2007-2009 financial crisis. Short-term creditors rushed for the exit and liquidity evaporated abruptly. The modern-day bank runs that occurred in the shadow banks (non-bank financial intermediaries) vividly illustrated how liquidity could suddenly dry up.
Xuewen Liu has developed a model to demonstrate the interdependence of trade in the interbank market and creditor runs on financial institutions. The model illustrates how banking crises arise from a shrinking of aggregate liquidity pool, helping to explain some important phenomena in the recent crisis. For example, this particular predicament originated in the US with the subprime mortgage crisis. However, the first bank to suffer a run was Northern Rock, a UK bank. Both Northern Rock and the US institutions tapped the same short-term funding market.
The credit risk of debt in a financial institution can be divided into two: fundamental, or insolvency, risk, and coordination, or illiquidity, risk. In the model’s framework, the illiquidity risk is internal, originating in the insolvency risk. When the insolvency risk increases, the coordination problem among short-term creators becomes more severe, thus they are more likely to make a run on the institution, so the illiquidity risk also increases. In this model, the role of the interbank market is to allow banks with idiosyncratic financial shocks to trade short-term funds to solve their illiquidity problem and thus mitigate potential creditor runs.
The model considers two post- event intervention measures: liquidity injections and public disclosure. First, when a negative aggregate shock hits, injections of liquidity into the financial system are crucial to break the vicious cycle of feedback. The model emphasizes that when the banking system is hit by an aggregate shock, the purpose of government intervention with liquidity injections is not to save a single bank, but to influence the interaction among banks and with creditors within the system and thereby improve overall efficiency. Second, public disclosure can improve efficiency. If the government is informed of the asset quality of individual banks, such as through stress tests, for example, there exists an optimal degree of transparency in public disclosure. Neither too much nor too little disclosure is efficient.
Liu’s paper is related to research that uses global game methods to address illiquidity risk. His research contributes to this literature in that it enables study of the interplay between illiquidity risk and insolvency risk in a financial system by considering the interbank market, as well as analyzing the systemic effects that play a large role in a crisis. It explicitly models the interbank market, explaining feedback loops between creditor runs and interbank trading, and examines the transmission of shocks across institutions through the interbank market. It also highlights how the feedback between runs on financial institutions and trade in the interbank market can amplify a small shock into a systemic crisis. The model shows that the creditor-run equilibrium in the system affects — and is, in turn, affected by — the interbank rate.
