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.