Ebook Contagion Among Interbank Money Markets During the Subprime Crisis
The severity of the recent subprime crisis has taken many economists and nancial market participants by surprise. One of the most remarkable symptoms of the crisis was the observed strain in interbank money markets, showing up in sharply increasing money market rates. The rates for unsecured and secured lending diverged tremendously. Interpreting the spread of these rates (the repo spreads) as risk premia for interbank lending, the crisis appears to have led to a massive decline in the banks' (perceived) creditworthiness.
Interestingly, repo spreads did not only increase, but they also became highly correlated across di erent regions (US, UK and euro area) during the turmoil. This paper investigates whether the observed rise in correlations is due to a contagion e ect among interbank money markets. In fact, it is frequently argued that the problems underlying the recent nancial turmoil originated in the United States and spilled over to other regions worldwide. The role of interbank money markets in this process will be discussed.
To shed light on these issues, we start by analyzing the dynamics of the repo spreads from the US, UK, and the euro area in a VAR framework. Our empirical results con rm the existence of contagion in interbank money markets during the crisis: a shock to the repo spread in one region is transmitted to the other regions; the same cannot be observed for the period prior to August 2007. Interestingly, shocks are not only transmitted from the US to the UK and the euro area, but at least partly also in the opposite direction.
We further analyze the e ectiveness of central bank actions in easing the strains in interbank money markets. Central bank actions are found to have signi cantly decreased repo spreads in the respective money market during the crisis, indicating that central bank actions indeed contributed to a stabilization of interbank markets. Particularly large e ects are found for central bank actions concerning the range of acceptable collateral and the introduction of new lending facilities. These results are remarkable because they imply that banks' risk premia (i.e., banks' solvency) are a ected by the liquidity provision by central banks. They suggest that liquidity problems lay at the core of the turmoil in interbank money markets.
Another noteworthy nding concerns the transmission of liquidity-providing central bank actions across interbank money markets. We nd that central bank operations in one region also a ected repo spreads in the other regions. Again this is especially true for transactions regarding collateral and new lending facilities. This suggests that liquidity also plays an important role in the transmission of shocks across interbank money markets.
Our paper is related to two strands in the literature. First, there are a number of empirical papers evaluating the e ectiveness of the Term Auction Facility (TAF), introduced in December 2007, in cooling down the strains in the US money market (e.g. McAndrews, Sarkar, and Wang (2008), Sack and Meyer (2008), Taylor and Williams (2009) and Wu (2008)).
The liquidity risk component in the expectations-adjusted interest rate spread (OIS spread) is at the center of these studies. These papers investigate neither the cross-country e ects of these measures, nor the measures conducted by other central banks. The second group in the literature focuses on the risk decomposition in money market rates (e.g. Schwarz (2008) and Brunnermeier (2008)). They try to disentangle credit default risk from liquidity risk, but do not measure the e ect of central bank interventions. The contribution our this study will be to analyzes all major central bank interventions for the euro area, UK and US on a national and cross-country basis. In addition, we will focus on the credit risk component of money market rates.
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