Interbank lending market
Encyclopedia
The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate (also called the overnight rate if the term of the loan is overnight). Low transaction volume in this market was a major contributing factor to the financial crisis of 2007.
Banks are required to hold an adequate amount of liquid assets, such as cash
, to manage any potential bank run
s by clients. If a bank cannot meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets.
The interbank rate is the rate of interest charged on short-term loans between banks. Banks borrow and lend money in the interbank lending market in order to manage liquidity and satisfy regulations such as reserve requirement
s. The interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract, such as term length. There is a wide range of published interbank rates, including the federal funds rate
(USA), the LIBOR (UK) and the Euribor
(Eurozone).
The money market
is a subsection of the financial market in which funds are loaned and borrowed for periods of one year or less. Funds are transferred through the purchase and sale of money market instruments—highly liquid short-term debt securities. These instruments are considered cash equivalents since they can be sold in the market easily and at low cost. They are commonly issued in units of at least one million and tend to have maturities of three months or less. Since active secondary market
s exist for almost all money market instruments, investors can sell their holdings prior to maturity. The money market is an over-the-counter
(OTC) market.
Banks
are key players in several segments of the money market. To meet reserve requirements and manage day-to-day liquidity needs, banks buy and sell short-term uncollateralized loans in the federal funds market
. For longer maturity loans, banks can tap the Eurodollar
market. Eurodollars are dollar-denominated deposit liabilities of banks located outside the United States (or of International Banking Facilities in the United States). US banks can raise funds in the Eurodollar market through their overseas branches and subsidiaries. A second option is to issue large negotiable certificates of deposit (CDs). These are certificates issued by banks which state that a specified amount of money has been deposited for a period of time and will be redeemed with interest at maturity. Repurchase agreements (repos) are yet another source of funding. Repos and reverse repos are transactions in which a borrower agrees to sell securities to a lender and then to repurchase the same or similar securities after a specified time, at a given price, and including interest at an agreed-upon rate. Repos are collateralized or secured loans
in contrast to federal funds loans which are unsecured.
Funding liquidity risk captures the inability of a financial intermediary to service its liabilities as they fall due. This type of risk is particularly relevant for banks since their business model involves funding long-term loans through short-term deposits and other liabilities. The healthy functioning of interbank lending markets can help reduce funding liquidity risk because banks can obtain loans in this market quickly and at little cost. When interbank markets are dysfunctional or strained, banks face a greater funding liquidity risk which in extreme cases can result in insolvency.
In the past, checkable deposits were US banks’ most important source of funds; in 1960, checkable deposits comprised more than 60 percent of banks’ total liabilities. Over time, however, the composition of banks’ balance sheets has changed significantly. In lieu of customer deposits, banks have increasingly turned to short-term liabilities such as commercial paper
(CP), certificates of deposit (CDs), repurchase agreement
s (repos), swapped foreign exchange liabilities, and brokered deposits.
s (FRNs), adjustable-rate mortgages (ARMs), and syndicated loan
s. These benchmark rates are also commonly used in corporate cashflow analysis as discount rates. Thus, conditions in the unsecured interbank market can have wide-reaching effects in the financial system and the real economy by influencing the investment decisions of firms and households.
Efficient functioning of the markets for such instruments relies on well-established and stable reference rates. The benchmark rate used to price many US financial securities is the three-month US dollar Libor rate. Up until the mid-1980s, the Treasury bill rate was the leading reference rate. However, it eventually lost its benchmark status to Libor due to pricing volatility caused by periodic, large swings in the supply of bills. In general, offshore reference rates such as the US dollar Libor rate are preferred to onshore benchmarks since the former are less likely to be distorted by government regulations such as capital control
s and deposit insurance
.
by manipulating instruments to achieve a specified value of an operating target. Instruments refer to the variables that central banks directly control; examples include reserve requirements, the interest rate paid on funds borrowed from the central bank, and balance sheet composition. Operating targets are typically measures of bank reserves
or short-term interest rates such as the overnight interbank rate. These targets are set to achieve specified policy goals which differ across central banks depending on their specific mandates.1
US monetary policy implementation involves intervening in the unsecured interbank lending market known as the fed funds market. Federal funds
(fed funds) are uncollateralized loans of reserve balances at Federal Reserve banks. The majority of lending in the fed funds market is overnight, but some transactions have longer maturities. The market is an over-the-counter
(OTC) market where parties negotiate loan terms either directly with each other or through a fed funds broker. Most of these overnight loans are booked without a contract and consist of a verbal agreement between parties. Participants in the fed funds market include: commercial bank
s, savings and loan association
s, branches of foreign banks in the US, federal agencies, and primary dealers.
Depository institution
s in the US are subject to reserve requirements, regulations set by the Board of Governors of the Federal Reserve which oblige banks to keep a specified amount of funds (reserves) in their accounts at the Fed as insurance against deposit outflows and other balance sheet fluctuations. It is common for banks to end up with too many or too few reserves in their accounts at the Fed. Up until October 2008, banks had the incentive to lend out idle funds since the Fed did not pay interest on excess reserves
The interest rate channel of monetary policy refers to the effect of monetary policy actions on interest rates that influence the investment and consumption decisions of households and businesses. Along this channel, the transmission of monetary policy to the real economy relies on linkages between central bank instruments, operating targets, and policy goals. For example, when the Federal Reserve conducts open market operations in the federal funds market, the instrument it is manipulating is its holdings of government securities
. The Fed's operating target is the overnight federal funds rate and its policy goals are maximum employment, stable prices, and moderate long-term interest rates. For the interest rate channel of monetary policy to work, open market operations must affect the overnight federal funds rate which must influence the interest rates on loans extended to households and businesses.
As explained in the previous section, many US financial instruments are actually based on the US dollar Libor rate, not the effective federal funds rate. Successful monetary policy transmission thus requires a linkage between the Fed's operating targets and interbank lending reference rates such as Libor. During the 2007 financial crisis, a weakening of this linkage posed major challenges for central banks and was one factor that motivated the creation of liquidity and credit facilities. Thus, conditions in interbank lending markets can have important effects on the implementation and transmission of monetary policy.
. For example, in June of 2007, ratings agencies downgraded over 100 bonds backed by second-lien subprime mortgages. Soon after, the investment bank Bear Stearns
liquidated two hedge fund
s that had invested heavily in mortgage-backed securities
(MBS) and a few large mortgage lenders filed for Chapter 11 bankruptcy protection. Strains in interbank lending markets became apparent on August 9, 2007, after BNP Paribas
announced that it was halting redemptions on three of its investment funds. That morning the US dollar Libor rate climbed over 10 basis points (bps) and remained elevated thereafter. The US Libor-OIS spread ballooned to over 90bps in September whereas it had averaged 10bps in prior months.
At the following FOMC meeting (September 18, 2007), the Fed started to ease monetary policy aggressively in response to the turmoil in financial markets. In the minutes from the September FOMC meeting, Fed officials characterize the interbank lending market as significantly impaired:
“Banks took measures to conserve their liquidity and were cautious about counterparties’ exposures to asset-backed commercial paper. Term interbank funding markets were significantly impaired, with rates rising well above expected future overnight rates and traders reporting a substantial drop in the availability of term funding.”
By the end of 2007, the Federal Reserve had cut the fed funds target rate by 100bps and initiated several liquidity-providing programs and yet the Libor-OIS spread remained elevated. Meanwhile, for most of 2008, term funding conditions remained stressed. In September 2008, when the US government decided not to bail out the investment bank Lehman Brothers
, credit markets went from being strained to completely broken and the Libor-OIS spread blew out to over 350bps.
An increase in counterparty risk reduces lending banks’ expected payoffs from providing unsecured funds to other banks and thus lowers their incentive to transact with one another. This is a result from Stiglitz and Weiss (1981): the expected return on a loan to a bank is a decreasing function of the riskiness of the loan. Stiglitz and Weiss also show that increases in funding costs can lead safe borrowers to drop out of the market, making the remaining pool of borrowers more risky. Thus, adverse selection may have exacerbated strains in interbank lending markets once Libor rates were on the rise.
The market environment at the time was not inconsistent with an increase in counterparty risk and a higher degree of information asymmetry
. In the second half of 2007, market participants and regulators started to become aware of the risks in securitized products and derivatives. Many banks were in the process of writing down the values of their mortgage-related portfolios. House prices were falling all over the country and the ratings agencies had just started to downgrade subprime mortgages. Concerns about structured investment vehicle
s (SIVs) and mortgage and bond insurers
were growing. Moreover, there was very high uncertainty about how to value complex securitized instruments and where in the financial system these securities were concentrated.
Another possible explanation for the seizing up of interbank lending is that banks were hoarding liquidity in anticipation of future shortages. Two modern features of the financial industry suggest this hypothesis is not implausible. First, banks have come to rely much less on deposits as a source of funds and more on short-term wholesale funding (brokered CDs, asset-backed commercial paper (ABCP), interbank repurchase agreement
s etc.). Many of these markets came under stress during the early phase of the crisis, particularly the ABCP market. This meant banks had fewer sources of funds to turn to, although an increase in retail deposits over this period provided some offset.
Second, it has become common for corporations to turn to markets rather than banks for short-term funding. In particular, before the crisis firms were regularly tapping commercial paper markets for funds. These corporations still had lines of credit set up with banks, but they used them more as a source of insurance. After the near collapse of the commercial paper market, however, firms took advantage of this insurance and banks had no choice but to provide the liquidity. Thus, firms’ use of credit lines during the crisis increased illiquidity risks for banks. Lastly, banks’ off-balance sheet programs (SIVs for example) relied on short-term ABCP to operate; when this market dried up, banks in some cases had to take the assets from these vehicles onto their balance sheets. All of these factors made liquidity risk management especially challenging during this time.
The effective federal funds rate is the weighted average rate at which banks lend to each other in the overnight fed funds market; also known as the US overnight rate. Note that the effective fed funds rate is different from the target fed funds rate, which is the rate decided on by members of the Federal Open Market Committee when they meet several times a year to discuss monetary policy.
The US dollar Libor rate, short for the London interbank offer rate, is the rate at which banks indicate they are willing to lend to other banks for a specified term. More specifically it is the British Banker's Association average of interbank rates for dollar deposits in the London market. Term Libor rates reflect the expected path of monetary policy as well as a risk premium associated with credit and liquidity risks.
Banks are required to hold an adequate amount of liquid assets, such as cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
, to manage any potential bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
s by clients. If a bank cannot meet these liquidity requirements, it will need to borrow money in the interbank market to cover the shortfall. Some banks, on the other hand, have excess liquid assets above and beyond the liquidity requirements. These banks will lend money in the interbank market, receiving interest on the assets.
The interbank rate is the rate of interest charged on short-term loans between banks. Banks borrow and lend money in the interbank lending market in order to manage liquidity and satisfy regulations such as reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
s. The interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract, such as term length. There is a wide range of published interbank rates, including the federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
(USA), the LIBOR (UK) and the Euribor
Euribor
The Euro Interbank Offered Rate is a daily reference rate based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market .-Scope:...
(Eurozone).
Interbank segment of the money market
The interbank lending market refers to the subset of bank-to-bank transactions that take place in the money market.The money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
is a subsection of the financial market in which funds are loaned and borrowed for periods of one year or less. Funds are transferred through the purchase and sale of money market instruments—highly liquid short-term debt securities. These instruments are considered cash equivalents since they can be sold in the market easily and at low cost. They are commonly issued in units of at least one million and tend to have maturities of three months or less. Since active secondary market
Secondary market
The page applies to the finanical term; For the merchandising concept, see Aftermarket .The secondary market, also called aftermarket, is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold....
s exist for almost all money market instruments, investors can sell their holdings prior to maturity. The money market is an over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC) market.
Banks
Banks
Banks or The Banks may refer to:* Bank, a financial institution- Placenames :Australia* Banks, Australian Capital Territory, a suburb of Canberra...
are key players in several segments of the money market. To meet reserve requirements and manage day-to-day liquidity needs, banks buy and sell short-term uncollateralized loans in the federal funds market
Federal funds
In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions...
. For longer maturity loans, banks can tap the Eurodollar
Eurodollar
Eurodollars are time deposits denominated in U.S. dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the U.S., allowing for higher margins. The term...
market. Eurodollars are dollar-denominated deposit liabilities of banks located outside the United States (or of International Banking Facilities in the United States). US banks can raise funds in the Eurodollar market through their overseas branches and subsidiaries. A second option is to issue large negotiable certificates of deposit (CDs). These are certificates issued by banks which state that a specified amount of money has been deposited for a period of time and will be redeemed with interest at maturity. Repurchase agreements (repos) are yet another source of funding. Repos and reverse repos are transactions in which a borrower agrees to sell securities to a lender and then to repurchase the same or similar securities after a specified time, at a given price, and including interest at an agreed-upon rate. Repos are collateralized or secured loans
Secured loan
A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan...
in contrast to federal funds loans which are unsecured.
A source of funds for banks
Interbank loans are important for a well-functioning and efficient banking system. Since banks are subject to regulations such as reserve requirements, they may face liquidity shortages at the end of the day. The interbank market allows banks to smooth through such temporary liquidity shortages and reduce funding liquidity risk.Funding liquidity risk
Funding liquidity risk captures the inability of a financial intermediary to service its liabilities as they fall due. This type of risk is particularly relevant for banks since their business model involves funding long-term loans through short-term deposits and other liabilities. The healthy functioning of interbank lending markets can help reduce funding liquidity risk because banks can obtain loans in this market quickly and at little cost. When interbank markets are dysfunctional or strained, banks face a greater funding liquidity risk which in extreme cases can result in insolvency.
Longer-term trends in banks' sources of funds
In the past, checkable deposits were US banks’ most important source of funds; in 1960, checkable deposits comprised more than 60 percent of banks’ total liabilities. Over time, however, the composition of banks’ balance sheets has changed significantly. In lieu of customer deposits, banks have increasingly turned to short-term liabilities such as commercial paper
Commercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
(CP), certificates of deposit (CDs), repurchase agreement
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
s (repos), swapped foreign exchange liabilities, and brokered deposits.
Benchmarks for short-term lending rates
Interest rates in the unsecured interbank lending market serve as reference rates in the pricing of numerous financial instruments such as floating rate noteFloating rate note
Floating rate notes are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months, though counter...
s (FRNs), adjustable-rate mortgages (ARMs), and syndicated loan
Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....
s. These benchmark rates are also commonly used in corporate cashflow analysis as discount rates. Thus, conditions in the unsecured interbank market can have wide-reaching effects in the financial system and the real economy by influencing the investment decisions of firms and households.
Efficient functioning of the markets for such instruments relies on well-established and stable reference rates. The benchmark rate used to price many US financial securities is the three-month US dollar Libor rate. Up until the mid-1980s, the Treasury bill rate was the leading reference rate. However, it eventually lost its benchmark status to Libor due to pricing volatility caused by periodic, large swings in the supply of bills. In general, offshore reference rates such as the US dollar Libor rate are preferred to onshore benchmarks since the former are less likely to be distorted by government regulations such as capital control
Capital control
Capital controls are measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate the flows into and out of the country's capital account....
s and deposit insurance
Deposit insurance
Explicit deposit insurance is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank's inability to pay its debts when due...
.
Monetary policy transmission
Central banks in many economies implement monetary policyMonetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
by manipulating instruments to achieve a specified value of an operating target. Instruments refer to the variables that central banks directly control; examples include reserve requirements, the interest rate paid on funds borrowed from the central bank, and balance sheet composition. Operating targets are typically measures of bank reserves
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...
or short-term interest rates such as the overnight interbank rate. These targets are set to achieve specified policy goals which differ across central banks depending on their specific mandates.1
US federal funds market
US monetary policy implementation involves intervening in the unsecured interbank lending market known as the fed funds market. Federal funds
Federal funds
In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear financial transactions...
(fed funds) are uncollateralized loans of reserve balances at Federal Reserve banks. The majority of lending in the fed funds market is overnight, but some transactions have longer maturities. The market is an over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC) market where parties negotiate loan terms either directly with each other or through a fed funds broker. Most of these overnight loans are booked without a contract and consist of a verbal agreement between parties. Participants in the fed funds market include: commercial bank
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...
s, savings and loan association
Savings and loan association
A savings and loan association , also known as a thrift, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans...
s, branches of foreign banks in the US, federal agencies, and primary dealers.
Depository institution
Depository institution
A depository institution is a financial institution in the United States that is legally allowed to accept monetary deposits from consumers...
s in the US are subject to reserve requirements, regulations set by the Board of Governors of the Federal Reserve which oblige banks to keep a specified amount of funds (reserves) in their accounts at the Fed as insurance against deposit outflows and other balance sheet fluctuations. It is common for banks to end up with too many or too few reserves in their accounts at the Fed. Up until October 2008, banks had the incentive to lend out idle funds since the Fed did not pay interest on excess reserves
Interest rate channel of monetary policy
The interest rate channel of monetary policy refers to the effect of monetary policy actions on interest rates that influence the investment and consumption decisions of households and businesses. Along this channel, the transmission of monetary policy to the real economy relies on linkages between central bank instruments, operating targets, and policy goals. For example, when the Federal Reserve conducts open market operations in the federal funds market, the instrument it is manipulating is its holdings of government securities
Federal Reserve System Open Market Account
The Federal Reserve System Open Market Account is one of monetary policy tool used by Federal Reserve System. It consists of the Federal Reserve's domestic and foreign portfolios. The SOMA domestic portfolio consists of U.S. Treasury securities held on both an outright and a temporary basis...
. The Fed's operating target is the overnight federal funds rate and its policy goals are maximum employment, stable prices, and moderate long-term interest rates. For the interest rate channel of monetary policy to work, open market operations must affect the overnight federal funds rate which must influence the interest rates on loans extended to households and businesses.
As explained in the previous section, many US financial instruments are actually based on the US dollar Libor rate, not the effective federal funds rate. Successful monetary policy transmission thus requires a linkage between the Fed's operating targets and interbank lending reference rates such as Libor. During the 2007 financial crisis, a weakening of this linkage posed major challenges for central banks and was one factor that motivated the creation of liquidity and credit facilities. Thus, conditions in interbank lending markets can have important effects on the implementation and transmission of monetary policy.
Strains in interbank lending markets during the 2007 financial crisis
By mid-2007, cracks started to appear in markets for asset-backed securitiesAsset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
. For example, in June of 2007, ratings agencies downgraded over 100 bonds backed by second-lien subprime mortgages. Soon after, the investment bank Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
liquidated two hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s that had invested heavily in mortgage-backed securities
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
(MBS) and a few large mortgage lenders filed for Chapter 11 bankruptcy protection. Strains in interbank lending markets became apparent on August 9, 2007, after BNP Paribas
BNP Paribas
BNP Paribas S.A. is a global banking group, headquartered in Paris, with its second global headquarters in London. In October 2010 BNP Paribas was ranked by Bloomberg and Forbes as the largest bank and largest company in the world by assets with over $3.1 trillion. It was formed through the merger...
announced that it was halting redemptions on three of its investment funds. That morning the US dollar Libor rate climbed over 10 basis points (bps) and remained elevated thereafter. The US Libor-OIS spread ballooned to over 90bps in September whereas it had averaged 10bps in prior months.
At the following FOMC meeting (September 18, 2007), the Fed started to ease monetary policy aggressively in response to the turmoil in financial markets. In the minutes from the September FOMC meeting, Fed officials characterize the interbank lending market as significantly impaired:
“Banks took measures to conserve their liquidity and were cautious about counterparties’ exposures to asset-backed commercial paper. Term interbank funding markets were significantly impaired, with rates rising well above expected future overnight rates and traders reporting a substantial drop in the availability of term funding.”
By the end of 2007, the Federal Reserve had cut the fed funds target rate by 100bps and initiated several liquidity-providing programs and yet the Libor-OIS spread remained elevated. Meanwhile, for most of 2008, term funding conditions remained stressed. In September 2008, when the US government decided not to bail out the investment bank Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
, credit markets went from being strained to completely broken and the Libor-OIS spread blew out to over 350bps.
Increase in counterparty risk
An increase in counterparty risk reduces lending banks’ expected payoffs from providing unsecured funds to other banks and thus lowers their incentive to transact with one another. This is a result from Stiglitz and Weiss (1981): the expected return on a loan to a bank is a decreasing function of the riskiness of the loan. Stiglitz and Weiss also show that increases in funding costs can lead safe borrowers to drop out of the market, making the remaining pool of borrowers more risky. Thus, adverse selection may have exacerbated strains in interbank lending markets once Libor rates were on the rise.
The market environment at the time was not inconsistent with an increase in counterparty risk and a higher degree of information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
. In the second half of 2007, market participants and regulators started to become aware of the risks in securitized products and derivatives. Many banks were in the process of writing down the values of their mortgage-related portfolios. House prices were falling all over the country and the ratings agencies had just started to downgrade subprime mortgages. Concerns about structured investment vehicle
Structured investment vehicle
A structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...
s (SIVs) and mortgage and bond insurers
Bond insurance
Bond insurance is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security...
were growing. Moreover, there was very high uncertainty about how to value complex securitized instruments and where in the financial system these securities were concentrated.
Liquidity hoarding
Another possible explanation for the seizing up of interbank lending is that banks were hoarding liquidity in anticipation of future shortages. Two modern features of the financial industry suggest this hypothesis is not implausible. First, banks have come to rely much less on deposits as a source of funds and more on short-term wholesale funding (brokered CDs, asset-backed commercial paper (ABCP), interbank repurchase agreement
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
s etc.). Many of these markets came under stress during the early phase of the crisis, particularly the ABCP market. This meant banks had fewer sources of funds to turn to, although an increase in retail deposits over this period provided some offset.
Second, it has become common for corporations to turn to markets rather than banks for short-term funding. In particular, before the crisis firms were regularly tapping commercial paper markets for funds. These corporations still had lines of credit set up with banks, but they used them more as a source of insurance. After the near collapse of the commercial paper market, however, firms took advantage of this insurance and banks had no choice but to provide the liquidity. Thus, firms’ use of credit lines during the crisis increased illiquidity risks for banks. Lastly, banks’ off-balance sheet programs (SIVs for example) relied on short-term ABCP to operate; when this market dried up, banks in some cases had to take the assets from these vehicles onto their balance sheets. All of these factors made liquidity risk management especially challenging during this time.
Effective federal funds rate
The effective federal funds rate is the weighted average rate at which banks lend to each other in the overnight fed funds market; also known as the US overnight rate. Note that the effective fed funds rate is different from the target fed funds rate, which is the rate decided on by members of the Federal Open Market Committee when they meet several times a year to discuss monetary policy.
US dollar Libor rate
The US dollar Libor rate, short for the London interbank offer rate, is the rate at which banks indicate they are willing to lend to other banks for a specified term. More specifically it is the British Banker's Association average of interbank rates for dollar deposits in the London market. Term Libor rates reflect the expected path of monetary policy as well as a risk premium associated with credit and liquidity risks.
See also
- Financial crisis of 2007
- Market liquidityMarket liquidityIn business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
- Liquidity crisisLiquidity crisisIn financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
- Money marketMoney marketThe money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
- LiborLondon Interbank Offered RateThe LIBOR rate is the average interest rate that leading banks in London charge when lending to other banks. It is an acronym for London Interbank Offered Rate Banks borrow money for one day, one month, two months, six months, one year etc. and they pay interest to their lenders based on...
- EuriborEuriborThe Euro Interbank Offered Rate is a daily reference rate based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market .-Scope:...
- Libor-OIS spreadLIBOR-OIS spreadThe LIBOR–OIS is the difference between LIBOR and the overnight indexed swap rates. The spread between the two rates is considered to be a measure of health of the banking system.-Risk barometer:...