Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads

Wide and volatile interest rate spreads in the 2007-2009 financial crisis could represent concerns over asset liquidity or issuer solvency. To precisely identify the contribution of these two effects on sovereign bond and interbank spreads, I propose a model-free measure of euro-area market liquidity, and a measure of near-term interbank default risk. I find that credit and liquidity are independently important. In interbank risk spreads, the role of liquidity dominates, while the importance in sovereign bond yield spreads varies substantially by country and maturity. To better understand the liquidity channel that is captured by the new liquidity measure, but is understated by extant measures, I test the pricing of liquidity risk; the possibility that liquidity could be negatively correlated with marginal utility. I exploit the variation in returns over countries, maturities and time, and find that liquidity euro-area sovereign bond risk premia are large and significant.