The 2007 Subprime Market Crisis Through the Lens of European Central Bank Auctions for Short Term Funds
In this paper we study European banks' demand for short term funds (liquidity) during the summer 2007 subprime market crisis. We use bidding data from the European Central Bank's auctions for one week loans, their main channel of monetary policy implementation. Through a model of bidding, we show that banks' behavior reflects their cost of obtaining short term funds elsewhere (i.e. in the interbank market) as well as a strategic response to other bidders. We find considerable heterogeneity across banks in their willingness to pay for short term funds supplied in these auctions. Accounting for the strategic component is important: while a naive interpretation of the raw bidding data may suggest that virtually all banks suffered a dramatic increase in the cost of obtaining funds in the interbank market, we find that for about one third of the banks, the change in bidding behavior was simply a strategic response. Using a complementary data set, we also find that banks' pre turmoil liquidity costs, as estimated by our model, are predictive of their post turmoil liquidity costs, and that there is considerable heterogeneity in these costs with respect to the country of origin. Finally, among the publicly traded banks, the willingness to pay for short term funds in the second half of 2007 are predictive of stock prices in late 2008.