Viral Acharya, C.V. Starr Professor of Economics and Director of the NSE-NYU Stern Initiative on the Study of Indian Capital Markets, and his co-author, Ouarda Merrouche at The World Bank, studied the liquidity demand of large settlement banks in the UK and its effect on the Sterling Money Markets before and during the sub-prime crisis of 2007-08. They found that liquidity holdings of large settlement banks experienced on average a 30 percent increase in the period immediately following August 9, 2007 (the day when money markets froze, igniting the crisis). Following this structural break, settlement bank liquidity had a precautionary nature in that it rose on calendar days with a large amount of payment activity and more so for weaker banks. The researchers established that the liquidity demand by settlement banks caused overnight inter-bank rates to rise, an effect that was virtually absent in the pre-crisis period. This liquidity effect on inter-bank rates occurred in both unsecured borrowing as well as borrowing secured by UK government bonds. Further, the effect was experienced by all settlement banks, regardless of their credit risk, suggestive of an interest-rate contagion from weaker to stronger banks operating through the inter-bank markets. This paper is forthcoming in the Review of Finance. View the paper here.
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