Introduction

This Chapter explores a critical aspect of the 2007-2009 financial crisis—the trends in short-term wholesale funding markets and their role in exacerbating the crisis. Short-term wholesale funding markets are integral to financial institutions’ liquidity management, yet certain trends within these markets played a significant role in contributing to the turmoil that unfolded during the crisis.

Trends in Short-Term Wholesale Funding Markets and Their Impact on Systemic Risk

1) Overview of Short-Term Wholesale Funding Markets
Short-term wholesale funding markets involve borrowing and lending of funds by financial institutions with maturities typically ranging from overnight to a few months. These markets facilitate liquidity management and the financing of various operations within the financial system.

2) Growing Reliance on Short-Term Funding
Leading up to the crisis, financial institutions became increasingly reliant on short-term wholesale funding due to its apparent cost-effectiveness and flexibility. This funding source allowed institutions to meet their obligations and expand operations, but it also introduced vulnerabilities.

3) Run on the Shadow Banking System
The shadow banking system, comprising non-bank financial institutions, played a significant role in short-term wholesale funding. Investors seeking higher yields often provided funds to these entities, which, in turn, invested in long-term assets using short-term funds. This maturity mismatch made the system susceptible to sudden liquidity shortages.

4) Liquidity Risk and Systemic Vulnerabilities
As financial institutions borrowed in short-term markets to finance their activities, a liquidity risk emerged. The interconnectedness of institutions and their reliance on short-term funding created systemic vulnerabilities. A lack of confidence in the ability of institutions to repay their short-term obligations triggered a domino effect, leading to a widespread liquidity squeeze.

5) Impact on Systemic Risk
The systemic risk was amplified due to the interconnectivity of financial institutions and their reliance on short-term wholesale funding. When a few institutions faced liquidity challenges, it triggered concerns among creditors, causing a panic-driven withdrawal of funds from various entities. This interconnectedness resulted in a systemic contagion, contributing to the crisis.

Example: Asset-Backed Commercial Paper (ABCP) Market

The ABCP market, which involved short-term borrowing to finance longer-term assets, experienced severe disruptions during the crisis. Investors lost confidence in the quality of underlying assets, leading to a freeze in the market. This highlighted the risks associated with relying on short-term funding for long-term assets.