PDF Ebook Do Central Bank Liquidity Facilities Affect Interbank Lending Rates?
In early August 2007, amidst declining prices and credit ratings for U.S. mortgage-backed securities and other forms of structured credit, international money markets came under severe stress. Short-term funding rates in the interbank market rose sharply relative to yields on comparable-maturity government securities. For example, the three-month U.S. dollar London interbank offered rate (LIBOR) jumped from only 20 basis points higher than the three month U.S. Treasury yield during the first seven months of 2007 to over 110 basis points higher during the final five months of the year. This enlarged spread was also remarkable for persisting into 2008.
LIBOR rates are widely used as reference rates in financial instruments, including derivatives contracts, variable-rate home mortgages, and corporate notes, so their unusually high levels in 2007 and 2008 appeared likely to have widespread adverse financial and macroeconomic repercussions. To limit these adverse effects, central banks around the world established an extraordinary set of lending facilities that were intended to increase financial market liquidity and ease strains in term interbank funding markets, especially at maturities of a few months or more. Monetary policy operations typically focus on an overnight or very short-term interbank lending rate. However, on December 12, 2007, the Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, and the Swiss National Bank jointly announced a set of measures designed to address elevated pressures in term funding markets. These measures included foreign exchange swap lines established between the Federal Reserve and the ECB and the Swiss National Bank to provide U.S. dollar funding in Europe. The Federal Reserve also announced a new Term Auction Facility, or TAF, to provide depository institutions with a source of term funding. The TAF term loans were secured with various forms of collateral and distributed through an auction.
The TAF and similar term lending facilities by other central banks were not monetary policy actions as traditionally defined. Instead, these central bank actions were meant to improve the distribution of reserves and liquidity by targeting a narrow market-specific funding problem. The press release introducing the TAF described its purpose in this way: “By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress.” (Federal Reserve Board, December 12, 2007).
This paper assesses the effect of the establishment of these extraordinary central bank liquidity facilities on the interbank lending market and, in particular, on term LIBOR spreads over Treasury yields. In theory, the provision of central bank liquidity could lower the liquidity premium on interbank debt through a variety of channels. On the supply side, banks that have a greater assurance of meeting their own unforseen liquidity needs over time should be more willing to extend term loans to other banks. In addition, creditors should also be more willing to provide funding to banks that have easy and dependable access to funds, since there is a greater reassurance of timely repayment. On the demand side, with a central bank liquidity backstop, banks should be less inclined to borrow from other banks to satisfy any precautionary demand for liquid funds because their future idiosyncratic demands for liquidity over time can be met via the backstop. However, assessing the relative importance of these channels is difficult. Furthermore, judging the efficacy of central bank liquidity facilities in lowering the liquidity premium is complicated because LIBOR rates, which are for unsecured bank deposits, also include a credit risk premium for the possibility that the borrowing bank may default. The elevated LIBOR spreads during the financial crisis likely reflected both higher credit risk and liquidity premiums, so any assessment of the effect of the recent extraordinary central bank liquidity provision must also control for fluctuations in bank credit risk.
To analyze the effectiveness of the central bank liquidity facilities in reducing interbank lending pressures, we use a multifactor arbitrage-free (AF) representation of the term structure of interest rates and bank credit risk. Specifically, we estimate an affine arbitrage-free term structure representation of U.S. Treasury yields, the yields on bonds issued by financial institutions, and term LIBOR rates using weekly data from 1995 to midyear 2008. For tractability, the model uses the arbitrage-free Nelson Siegel (AFNS) structure. Christensen, Diebold, and Rudebusch (CDR, 2007) show that a three-factor AFNS model fits and forecasts the Treasury yield curve very well and avoids many of the estimation difficulties encountered with unrestricted AF latent factor models. In this paper, we incorporate three additional factors: two factors that capture bank debt risk dynamics, as in Christensen and Lopez (2008), and a third factor specific to LIBOR rates. The resulting six-factor representation provides arbitrage-free joint pricing of Treasury yields, financial corporate bond yields, and LIBOR rates. This structure allows us to decompose movements in LIBOR rates into changes in bank debt risk premiums and changes in a factor specific to the interbank market that includes a liquidity premium. We can also conduct hypothesis testing and counterfactual analysis related to the introduction of the central bank liquidity facilities.
Our results support the view that the central bank liquidity facilities established in December 2007 helped lower LIBOR rates. Specifically, the parameters governing the term LIBOR factor within the model are shown to change after the introduction of the liquidity facilities. The hypothesis of constant parameters is overwhelmingly rejected, suggesting that the behavior of this factor, and thus of the LIBOR market, was directly affected by the introduction of central bank liquidity facilities. To quantify this effect, we use the model to construct a counterfactual path for the 3-month LIBOR rate by assuming that the LIBOR-specific factor remained constant at its historical average after the introduction of the liquidity facilities. Our analysis suggests that the counterfactual 3-month LIBOR rate averaged significantly higher—on the order of 70 basis points higher—than the observed rate from December 2007 through the middle of 2008. Figure 1 shows the difference between the observed three-month LIBOR rate and our model-implied counterfactual path for that rate during this period. From the start of the financial crisis—which was triggered by an August 9, 2007, announcement by the French bank BNP Paribas—until the TAF and swap joint central bank announcement in mid-December 2007, the observed LIBOR rate averaged 8 basis points higher that the counterfactual rate. Such signs of distress in the interbank market helped spur the announcement of the central bank liquidity facilities. After that announcement, the difference between the observed three-month LIBOR rate and the counterfactual rate quickly turned negative and reached approximately -75 basis points, where it stayed for the remainder of our sample. This result suggests that if the central bank liquidity facilities had not been created, the 3-month LIBOR rate would have been substantially higher.
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PDF Ebook Do Central Bank Liquidity Facilities Affect Interbank Lending Rates?
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