Illiquidity Component of Credit Risk – The 2015 Lawrence R. Klein Lecture

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.