Widening of Libor: Liquidity or credit risk?

Simon Kwan of FRBSF has written a short note on how Libor has behaved in this crisis. He explains the Libor movement and asks what drove it- increase in liquidity risk or credit risk?

To study the risk premium in Libor rates, I first compare the Libor to the expected overnight interest rate over the same term. For example, to make loans in the interbank market for 30 days, a bank could make a one-month loan at the prevailing one-month Libor rate. Alternatively, the bank could make an overnight loan at, say, the federal funds rate and keep rolling it over for the next 30 days; the expected cumulative interest rate for this alternative is given by the 30-day Overnight Index Swap (OIS) rate.

The difference between the two lending strategies is that the bank using the one-month Libor is committed to lending the funds for one month and therefore has little control over them during the period. In the alternative strategy, the bank has full control in deciding whether to roll the overnight loan over each day. This rollover option safeguards the lender against unforeseen developments in the next 30 days, including an unexpected deterioration in the creditworthiness of the borrowing bank and other unexpected changes in the demand for liquidity both at the lending bank and in the market. Hence, the one-month Libor is always higher than the one-month OIS rate, and this spread reflects the risk premium for committing the funds for the full month.

He calculates the spread between monthly rate and the rollover rate for both 1 month and 3 months. The spread has widened sharply in recent months (obviously).

What leads to rise in this spread? Is it liqudity risk or credit risk?

To examine how much of the movement in the spread is driven by changes in credit risk, I examined the statistical relationship between Libor-OIS spreads and credit default swap (CDS) spreads of the banks in the Libor panel to examine the explanatory power of credit risk on the Libor spreads, using daily data from July 2007 to most recently available. The CDS spreads are the cost of buying credit insurance against the default of the bank on its debts, and they are used here to proxy for the underlying default risk of the banks in the Libor panel. The regression explained about 44% of the variation in Libor-OIS spreads, and the CDS spread had a highly statistically significant effect.

To study the liquidity premium, researchers have examined whether the liquidity facilities introduced by the Fed in general, and the TAF in particular, have had any effect on the Libor spreads. The empirical evidence to date is mixed; for example, Taylor and Williams (2008) do not find robust evidence of a significant effect, while McAndrews, Sarkar, and Wang (2008) conclude that a cumulative reduction of more than 50 basis points can be associated with the TAF announcements and its operations.

He says despite the best attempts to seperate, both credit and liquidity risk are connected

Testing or identifying the pure TAF effects on spreads is challenging, because credit risk and liquidity risk are most likely intertwined. As discussed earlier, an illiquid but otherwise solvent bank could become insolvent due to the inherent maturity mismatch between assets and liabilities in its portfolio.

He ends the note with a research question: 

 

Since December 2007, a series of initiatives by the Federal Reserve were introduced to address the liquidity in the short-term funding markets. Whether these facilities have any effects on Libor rates and spreads remains unresolved. Perhaps one could rephrase the question: Without any of the new liquidity facilities, would we expect the Libor rates to be at about the same levels they have been since the onset of the financial crisis?

One Response to “Widening of Libor: Liquidity or credit risk?”

  1. Tirath Says:

    Thanks

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