ILLIQUIDITY COMPONENT OF CREDIT RISK – THE 2015 LAWRENCE R. KLEIN LECTURE

• Author: Hyun Song Shin,Stephen Morris
• Date: 01 November 2016
• Published date: 01 November 2016
• DOI: http://doi.org/10.1111/iere.12192

INTERNATIONAL

ECONOMIC

REVIEW

November 2016

Vol. 57, No. 4

ILLIQUIDITY COMPONENT OF CREDIT RISK – THE 2015

LAWRENCE R. KLEIN LECTURE∗

BYSTEPHEN MORRIS AND HYUN SONG SHIN1

Princeton University, U.S.A; Bank for International Settlements, Switzerland

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.

1. INTRODUCTION

Credit risk refers to the risk of default by borrowers. In the simplest case, where the term of

the loan is identical to the term of the borrower’s cash flow, credit risk arises from the uncertainty

over the cash flow from the borrower’s project. However, the turmoil in credit markets in the

financial crisis that erupted in 2007 once again highlighted the limitations of focusing just on

the value of the asset side of banks’ balance sheets. The problem can be posed most starkly

for institutions such as Bear Stearns or Lehman Brothers that financed themselves through a

combination of short-term and long-term debt, but where the heavy use of short-term debt

made the institution vulnerable to a run by the short-term creditors.

The issue is highlighted in an open letter written by Christopher Cox, the (then) chairman of

the U.S. Securities and Exchange Commission (SEC) explaining the background and circum-

stances of the run on Bear Stearns in March 2008.2

[T]he fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult

began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the

weekend, the firm had a capital cushion well above what is required to meet supervisory standards

calculated using the Basel II standard.

∗Manuscript received June 2016; revised January 2016.

1We are grateful for comments from Viral Acharya, Christophe Chamley, Pete Kyle, Kohei Kawaguchi, and Yusuke

Narita as formal discussants of the article; from Sylvain Chassang, Masazumi Hattori, Eva Schliephake, Chester Spatt,

and Wei Xiong; and from participants in the Klein lecture and other seminars. Thomas Eisenbach and Elia Sartori

provided invaluable research assistance. We acknowledge support from the NSF grant #SES-0648806. An earlier version

of this article was first circulated in 2009 (see Morris and Shin, 2010). The current version of the article was prepared

as the Klein lecture at the University of Pennsylvania in September 2015. The views expressed here are those of the

authors and not necessarily those of the BIS.

Please address correspondence to: Stephen Morris, Department of Economics, Fisher Hall, Princeton, NJ 08544-

1021. Phone: +1-609-2584032. E-mail: smorris@princeton.edu.

2Letter to the Chairman of the Basel Committee on Banking Supervision, dated March 20, 2008, posted on the SEC

website on: http://www.sec.gov/news/press/2008/2008-48.htm.

1135

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(2016) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association