Crisis Management in Canada: Analyzing Default Risk and Liquidity Demand during Financial Stress†

American Economic Journal: Microeconomics 2021, 13(2): 243–275 https://doi.org/10.1257/mic.20160287 Crisis Management in Canada: Analyzing Default Risk and Liquidity Demand during Financial Stress By Jason Allen, Ali Hortaçsu, and Jakub Kastl* Using detailed information from the Canadian interbank payments system and liquidity-providing facilities, we find that despite sus- tained increases in market-rate spreads, the increase in banks’ willingness to pay for liquidity during the 2008–2009 financial crisis was short-lived. Our study suggests that high-frequency distress indicators based on demand for liquidity offered by central banks can be complementary, and perhaps even superior, to market-based indicators, especially during times and in markets where uncertainty in the economic environment may lead to lack of meaningful infor- mation in prices due to absence of trading. (JEL E42, E58, G01, G21, G28, H12) his paper uses transactions-le vel data from the Canadian unsecured interbank market and term liquidity auctions to evaluate the extent and dynamics of coun- terparty risk and to estimate market participants’ willingness to pay for liquidity during the global financial crisis of 2008–2009. The estimated willingness to pay for liquidity remains at lo w levels throughout almost the entire crisis and there appears to be little change in perceived counterparty risk. mark While et-based measures of default and liquidity risk increased, transactions data provides little support for the narrative that banks faced increasing costs of short-term borro wing. As the size of the COVID-19 pandemic became apparent and mark et-based measures of default and liquidity risk once again spiked, central banks injected unprecedented amounts of liquidity— super -sized versions of the facilities offered in 2008–2009. We high- light lessons learned from Canada during the global financial crisis and the value of...