ILLIQUIDITY COMPONENT OF CREDIT RISK – THE 2015 LAWRENCE R. KLEIN LECTURE |
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Authors: | Stephen Morris Hyun Song Shin |
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Institution: | Princeton University, U.S.A |
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Abstract: | We provide a theoretical decomposition of bank credit risk into insolvency risk and illiquidity risk, defining illiquidity risk to be the counterfactual probability of failure due to a run when the bank would have survived in the absence of a run. We show that illiquidity risk is (i) decreasing in the “liquidity ratio”—the ratio of realizable cash on the balance sheet to short‐term liabilities; (ii) decreasing in the excess return of debt; and (iii) increasing in the solvency uncertainty—a measure of the variance of the asset portfolio. |
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