Liquidity Risk and Funding Cost

We propose and test a new channel that links liquidity risk and interest rates in short-term funding markets. Unlike existing theories that focus on premiums demanded by lenders, the liquidity risk channel postulates that borrowers that are more exposed to urgent liquidity needs are willing to pay a markup for immediate funding. We test and quantify the channel using unique trade-by-trade data and uncover systematic differences across individual banks’ funding cost driven by differences in banks’ liquidity risk. These differences are persistent over a decade, suggesting that the liquidity risk channel is relevant in general and not only arises during crisis times.