Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

Submitted on 17th May 2019

Abstract - Euro-area sovereign bond and interbank interest rate spreads rose by more than an order of magnitude in the 2007-2009 Financial Crisis, sharply increasing financing costs. Such rate volatility could represent concerns over asset liquidity or issuer solvency. To precisely identify the relative contribution of these two effects in interest rate spreads, this paper uses a model-free measure of euro-area bond market liquidity. Liquidity accounts for 36% of the average trough-to-peak sovereign spread widening during the Crisis, after controlling for default risk. Aggregate bond liquidity also explains a substantial portion of interbank spreads, even after controlling for interbank credit and liquidity.

Length of Resource
54 pages
Krista Schwarz
Date Published