Mind the gap: disentangling credit and liquidity in risk spreads. Working Paper

Widening interest rate spreads observed since August 2007 could represent deteriorating liquidity or greater credit risk. I construct new microstructure measures of credit and liquidity and find that market liquidity effects explain more than two-thirds the widening of one- and three-month euro LIBOR-OIS spreads and of intra-euro-area sovereign debt spreads over the sample period. My new credit risk measure is an indicator of credit tiering in the interbank money market; my new liquidity measure uses the spread between bonds of differing liquidity that are all guaranteed by the German government, and that therefore should not be contaminated by any effects of credit. Over the sample period, my two measures are nearly orthogonal, making it possible to econometrically identify the separate effects of credit and liquidity. Previous literature finds that risk spreads are largely attributable to default risk, but I ascribe this to their mismeasurement of liquidity and credit