The interbank money market is the primary channel for the implementation of monetary policy for a number of central banks, including, for example, the European Central Bank (ECB) and the Bank of England. Steering overnight interest rates is crucial for these central banks as this provides an anchor for the term structure of interest rates. In the case of the euro area, the Euro Overnight Index Average (EONIA) is a weighted average of all overnight lending transactions between the most active credit institutions in the euro area’s money market. Effective steering of the overnight rate by the ECB would therefore imply a low spread between the ECB policy rate and the EONIA rate. Since the intensification of the October 2008, a very large spread became evident, however. This coincided with a range of liquidity easing measures by the ECB, leading to a large liquidity surplus across the Eurosystem. While a number of papers have examined the determinants of the EONIA spread in the pre-crisis period, there are very few (if any) that examine the period of the crisis. The purpose of this paper is to investigate this issue, using a Stochastic Volatility modelling approach. While the primary analysis is on the euro area, we will also carry out a comparative analysis for the UK, which also adopted enhanced liquidity-providing measures to counteract the lack of interbank market activity caused by the crisis.
In non-crisis times, excess volatility is not prevalent in the overnight interest rate as it tracks closely the main central bank policy rate, so that the spread between both is relatively low (i.e. less than five basis points). In crisis times, however, this is not necessarily the case, and in the recent crisis there has been a clear rise in both the level and volatility of the overnight interest rate spread. Clearly, in circumstances when volatility is higher, so too is uncertainty associated with the spread. During the recent crisis of 2007 to 2009, as liquidity dried up, a large policy spread was observed, particularly after the collapse of Lehman Brothers in mid-September 2008. This triggered an intensification of the crisis, and an expansion of central bank balance sheets as liquidity-providing measures were introduced. The result was a large liquidity surplus. In the case of the euro area, the EONIA rate fell below the minimum bid rate (MBR) in the MRO (main refinancing operations), as opposed to non-crisis times when EONIA normally trades above the MBR rate – see Figures A1 and A2 in the Appendix for more details.
The recent financial crisis has underscored the need to explicitly take into account liquidity risk in stress-testing frameworks. The manifestation of liquidity risk can rapidly move the system into the tail of the loss distribution through bank runs, the drying up of market liquidity or doubts of counterparties about banks’ liquidity conditions. In these situations liquidity can evaporate, making a bank subject to multiple possible equilibria with very different levels of liquidity supply (Banque de France, 2008). Liquidity risk is not only a source of banks’ funding risk (the ability to raise cash to fund the assets), but also has a strong link to market liquidity (the ability to convert assets into cash at a given price). The originate-to-distribute model has made banks increasingly dependent on market liquidity to secure funding by issuing securities on wholesale markets and by trading credits. As a result, banks have become more vulnerable to macroeconomic and financial shocks that may engender liquidity risk.
Various regulatory initiatives in response to the credit crisis have highlighted that banks’ stress-testing practices usually do not incorporate liquidity risk scenarios sufficiently (FSF, 2008). Banks often underestimate the severity of market-wide stress, such as the disruption of several key funding markets simultaneously (e.g. repo and securitisation markets). Moreover, banks do not systematically consider second-order effects that can amplify losses. These can be caused by idiosyncratic reputation effects and/or collective responses of market participants, leading to disturbing (endogenous) effects on markets. Banks have insufficient incentives to insure themselves against such risks (FSA, 2007). This is because holding liquidity buffers is costly and may create a competitive disadvantage. Besides, liquidity stresses have a very low probability and market participants could have the perception that central banks will intervene to provide liquidity in stressed markets.
The originality of the US unemployment insurance (UI thereafter) lies in the experience rated structure of the firms contribution rate. Contribution rates (or UI payroll tax rates) are varied on the basis of employers layoffs history. Firms that are more likely to cause someone to be unemployed should support the burden of the fiscal cost induced by their dismissal decisions. Basically, more dismissals or higher unemployment benefits result in a higher contribution rate the next period.
