Carrel:Funding risk

[jcjc0602]

Hi everyone,

There is one paragraph under the formula of total cost of liquidity in Topic 35 of 2012 study notes (chapter 18 of Carrel Philippe's funding risk).

The author says: "typically, when central bank rates decline, inter-bank market rates fall by a greater proportion. However, it may not hold when liquidity costs risk as bank's reliance on the inter-bank market for refinancing rises. If this is the case, as was in 2008, spreads merely measure credit risk and the opportunity cost of holding collateral, and liquidity risk is at its highest. "

I don't quiet understand the last sentence. Why it only measures credit risk and the opportunity cost of holding collateral? Why it doesn't measure liquidity cost while it is at its peak? Thanks!

 

[ShaktiRathore]

One possible answer to the above is that may be i am not wrong that during depression like that one of 2008 the need of refinancing increases between the banks but banks are not willing to lend to each other due to high credit risk involved due to suspicion by the lender that the other party might not be able to fulfill its obligation.So there is high credit risk involved and the obviously the collateral cost increases simultaneously. As need of refinancing is high the liquidity spread is almost negligible during depression. So finally the spread merely reflects the credit and the collateral spread.