Liquidity Risk and I nterbank Markets Brenda Gonzalez-Hermosillo MIT Sloan School of Management Disclaimer: The views in this presentation are those of the Authors and do not necessarily represent those of the IMF or IMF policy. 1
Agenda: Liquidity Risk and Interbank Markets � I. Recent Trends � II. Transmission of Liquidity Spillovers during the early stages of the crisis � Data and Methodology � III. Interbank Market Rates and Variance Decomposition � IV. Concluding Remarks 2
Agenda: Liquidity Risk and Interbank Markets � I. Recent Trends � II. Transmission of Liquidity Spillovers during the early stages of the crisis � Data and Methodology � III. Interbank Market Rates and Variance Decomposition � IV. Concluding Remarks 3
Recent Renew ed Pressures on Funding Markets Sources: Bloomberg L.P.; and IMF staff estimates. 1/ Forward USD LIBOR minus OIS spread based on December 2010 contract. 2/ Spread between 3-month euro/ U.S. dollar forex swap and 3-month U.S. overnight index swaps. 3/ Spread between 3-month USD LIBOR and the 3-month U.S. overnight interest index swap in basis points.
I. Recent Pressures Triggered by the Cristallisation of Sovereign Risks in Europe and Spillover Effects 5
Central bank liquidity support Central Bank Key Policy and Overnight Money Market Rates (In percent) 7 6 United Kingdom 5 Euro area 4 3 2 United States 1 0 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Source: Bloomberg L.P. Note: Central bank key policy rates are the following: for the United States, Federal funds target rate; for the United Kingdom, Bank of England's official bank rate; and for euro area, main refinancing operation minimum bid rate. Overnight money market rates are the following: for the United States, Federal funds effective rate; for the United Kingdom, Sterling overnight interbank average (SONIA); and for euro area, Euro overnight interbank average (EURONIA). 7
The Four Phases of the Crisis (10 ‐ yr sovereign swap spreads, percent) I. II. III. IV. 4 Financial Crisis Buildup Systemic Systemic Sovereign Outbreak Response Risk 3 2 1 0 ‐ 1 Jul ‐ 07 Jan ‐ 08 Jul ‐ 08 Jan ‐ 09 Jul ‐ 09 Jan ‐ 10 Germany France Italy Spain Netherlands Belgium Austria Greece Ireland Portugal 8 Source: IMF GFSR, April 2010
Sovereign Risk Spillovers Have Emerged as a Threat to Financial Stability Country level fiscal fundamentals/ vulnerabilities Sovereign Funding strains spillovers Financial system fragilities 9
Liquidity strains during the crisis…. 10
I n perspective…liquidity strains since the peak of the crisis Sources: Bloomberg L.P.; and IMF staff estimates. 1/ Forward USD LIBOR minus OIS spread based on December 2010 contract. 2/ Spread between 3-month euro/ U.S. dollar forex swap and 3-month U.S. overnight index swaps. 3/ Spread between 3-month USD LIBOR and the 3-month U.S. overnight interest index swap in basis points.
Liquidity strains during the crisis…. Three-Month LIBOR to Overnight Index Swap Spreads (In basis points) 400 United States United Kingdom 350 Euro area 300 250 200 150 100 50 0 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Source: Bloomberg L.P. 12
Liquidity strains during the crisis... Sources: Bloomberg L.P. 1/Spread between yields on 90 ‐ day U.S. asset ‐ backed commercial paper and on the 3 ‐ month U.S. Treasury bill. 2/The unweighted daily average of the five ‐ year credit default swaps for the following institutions: Morgan Stanley, Merrill Lynch, Goldman Sachs, JPMorgan, Deutsche Bank, Bank of America, Citigroup, Barclays, Credit Suisse, and UBS. 3/Spread between 3 ‐ month USD LIBOR and 3 ‐ month overnight index swap.
Liquidity strains during the crisis...
Agenda: Liquidity Risk and Interbank Markets � I. Recent Trends � II. Transmission of Liquidity Spillovers during the early stages of the crisis � Data and Methodology � III. Interbank Market Rates and Variance Decomposition � IV. Concluding Remarks 15
II. Transmission of Liquidity Spillovers * ABCP Funding Liquidity • The financial crisis of 2007 originated from the shock to the U.S. subprime mortgage market, but this trigger rapidly transmitted to the ABCP market. • Funding illiquidity experienced by SIVs and conduits as investors became unwilling to roll over the corresponding ABCP. • This idiosyncratic ABCP funding liquidity shock reflected increasing uncertainty with regard to the value of the underlying securities. Bank Funding Liquidity • The SIVs began calling on the contingent credit lines from the sponsoring banks, and the balance sheets of those financial institutions were strained by the reabsorption of the SIVs. • As a result, the level of interbanking lending declined both for reasons of liquidity and credit risk, leading to higher LIBOR spreads. (* ) Nathaniel Frank, Brenda Gonzalez-Hermosillo and Heiko Hesse (2008 a, 2008b, 2010). 16
Transmission of Liquidity Spillovers Market Liquidity Uncertainty with respect to overall market conditions led investors to • increase their demand for the safest and most liquid of all assets. • Flight to transparency. Volatility • Financial markets more generally showed signs of stress and uncertainty. Increasing both the volatility of markets, including equity markets. • 17
Transmission of Liquidity Spillovers Credit Default Risk • The crisis also brought to the forefront concerns about the soundness of a number of financial institutions: – Financial institutions saw a decline in the values of securitized mortgages and other asset ‐ backed securities, which resulted in extensive write ‐ downs. – Higher money market rates increased funding costs. Liquidity Spirals • Interrelation between market and funding liquidity. • Also account for cyclical effects between market and funding liquidity. 18
Agenda: Liquidity Risk and Interbank Markets � I. Recent Trends � II. Transmission of Liquidity Spillovers during the early stages of the crisis � Data and Methodology � III. Interbank Market Rates and Variance Decomposition � IV. Concluding Remarks 19
II. Data and Methodology The arguments above motivate the variable selection and support the analysis of the transmission of liquidity shocks across five different markets during the early stages of the crisis: • ABCP Spread: 3 ‐ months ABCP yield— 3 ‐ months U.S. Treasury Bill • Libor Spread: 3 ‐ months U.S. interbank Libor rate — overnight index swap • Spread between 5 ‐ year on ‐ the run vs. off ‐ the ‐ run U.S. Treasury bonds Stock Market Returns: S&P 500, change in returns (volatility) • • Credit default swaps spreads for a sample of representative Large Financial Complex Institutions (LFCIs) 20
21 II. Data and Methodology
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II. Data and Methodology 24
II. Data and Methodology United States: Stock Market Returns and CDS for LCFIs (First difference; in basis points) 15 15 Returns CDS 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 1/3/2006 3/6/2006 5/5/2006 7/6/2006 9/6/2006 11/7/2006 1/8/2007 3/9/2007 5/10/2007 7/11/2007 9/11/2007 11/12/2007 Sources: Bloomberg and IMF staff estimates. 25
II. Data and Methodology Dynamic Conditional Correlation (DCC) model by Engle (2002) • which allows for time ‐ varying correlations. This provides a generalization of the Constant Conditional Correlation (CCC) model by Bollerslev (1990). • Multivariate DCC GARCH framework. Correlation dynamics. Because of a break across all markets, we amend the DCC model • to account for a structural break. • Model in first differences to account for the nonstationarity of the variables in the crisis period. Confidence intervals constructed using either Monte Carlo or • bootstrapping techniques 26
Methodology • Sample Period: January 3, 2003 ‐ January 9, 2008. • These econometric techniques allow us to analyze the comovement of markets by inferring the correlations of the changes in the spreads discussed above – which in turn is essential in understanding whether the recent episode of financial distress has become systemic. 27
Main Findings: Transmission of Liquidity Spillovers * 1. Before the subprime crisis there is only limited correlation between markets. 2. During the crisis period, correlations become more important and bigger in magnitude. 3. Find a statistically significant break in the correlation structure across markets. (* ) Frank, Nathaniel, Brenda Gonzalez-Hermosillo and Heiko Hesse • “Transmission of Liquidity Shocks” 2010, in Robert W. Kolb (ed.), Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future , Hoboken, NJ: John Wiley & Sons, Inc. • “The Transmission of Liquidity Shocks during the Crisis” 2008b, in Central Banking , Vol. 19, No. 1. • "Global Transmission of Liquidity Shocks during the 2007 Supbrime Crisis” 2008a, IMF Working Paper WP/ 08/ 200. 28
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