Liquidity Risk and Funding Cost

We propose and test a new channel that links funding liquidity risk and interest rates in short-term funding markets. Unlike existing theories that focus on premiums demanded by lenders, the funding liquidity risk channel postulates that borrowers exposed to liquidity shocks 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 idiosyncratic liquidity risk. These differences are persistent over a decade, suggesting that the funding liquidity risk channel is relevant in general and not only arises during crisis times.