Abstract - Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis

Using data on the behavior of large settlement banks in the UK and the Sterling Money
Markets before and during the sub-prime crisis of 2007-08, we provide evidence of precautionary
hoarding of liquidity and its effect on inter-bank borrowing rates. Our evidence
consists of three pieces. First, we document that liquidity holdings of the large settlement
banks in the UK experienced on average a 30% increase in the period immediately following
9th August, 2007, the widely accepted date of money-market "freeze" during the sub-prime
crisis. Second, we show that following this structural break, bank liquidity had a precautionary
nature in that it rose on calendar days predicted to have a large amount of fluctuations
in payment and settlements activity and more so for banks that made larger losses during
the crisis. Third, using the payment and settlements activity as an instrument, we establish
a causal effect of bank liquidity on overnight inter-bank rates, in both secured and unsecured
markets, an effect that is virtually absent in the period before the crisis. Importantly,
precautionary hoardings by some settlement banks raised lending rates for all settlement
banks, suggestive of a contagion-style systemic risk operating through inter-bank rates. Finally,
variability in overnight inter-bank rates appears to have affected rates and volumes in
household as well as corporate lending.

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