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., intheinterbank 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 dataset, 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.