CEPR: small banks pay big premium during credit crunch

A paper published by the Centre of Economic Policy Research in April identifies a number of frictions in liquidity markets relating to small banks during periods of tight credit.

The paper finds market liquidity as well as bank-specific and market-wide factors affect the prices that banks pay for credit. This is captured here by borrowing rates in repos with the central bank and benchmarked by the overnight index swap.

Unlike previous studies in this area, the paper uses price data for a range of firms on their reserve requirements and actual reserve holdings. By using data at the individual bank level the author is able to gauge the extent to which a bank is short or long liquidity.

Results show that the price a bank pays for liquidity depends on the liquidity positions of other banks, as well as its own. Evidence suggests that liquidity squeezes occasionally occur and short banks pay more the larger is the potential for a squeeze.

The author concludes that the price paid for liquidity is decreasing in bank size and that small banks are more adversely affected by an increased potential for a squeeze. Healthier banks pay less, but contrary to what one might expect, banks in formal liquidity networks do not.

Click here to read paper