Liquidity Auctions, Fixed Rate Tenders and Bailouts in the EURO Zone

At the end of September 2008, following the bankruptcy of Lehman Brothers, the European Central Bank (ECB) abandoned its usual procedure of allocating short-term funds using an auction and implemented a full-allotment procedure. We show that the data from auctions preceding this change can be used to gain insights about the health of the individual banks and their future recourse to ECB-provided lending. Based on an equilibrium model of bidding, we estimate individual banks’ willingness-to-pay for loans, which we link to their cost of funding. We find that banks whose willingness-to-pay for short-term funds kept increasing through the months of 2008 benefited more from the switch: they were allocated relatively more liquidity and at a relatively cheaper rate than before. We also find that the dynamics of the willingness-to-pay during 2008 are correlated with changes in several balance sheet variables, such as write-offs, in the expected direction. Using data on targeted bailouts, we show that banks whose willingness to-pay increased substantially already in 2007 are much more likely to receive a bailout than those whose willingness-to-pay did not increase or started increasing later as the situation on the financial markets deteriorated further. Using our estimates of cost of funding we propose a new measure of systemic risk based on the propagation of a shock to one bank’s cost through the system. We find that the recent bailouts were targeted mostly at the most vulnerable banks according to our measures.