Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
MSc in Finance & International Business, Thesis Department of Business Studies Author: Zeynep Kuyucu
Supervisor: Morten Balling
Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Aarhus School of Business, University of Aarhus September 2009
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Abstract
The object of this study was to evaluate the tension in the international interbank and foreign exchange markets during the recent financial turmoil, 2007-2009. Information was mainly extracted from recent articles with newest possible data, Bank of International Settlement, and key central banks. In order to analyse the tension in the interbank markets by factors as credit and liquidity risk have been emphasised, whereas the analysis of the foreign exchange swap markets, the covered interest parity (CIP) set forth by Keynes (1923) in his Tract on Monetary Reform, and further elaborated by Tsiang (1959) has been applied. Order to explain the widened spreads in the Libor-OIS, unsecured and secured along with term rate spreads, credit default swaps (CDS), foreign exchange swap implied dollar rates, through factors such as credit risk, liquidity risk, market liquidity, funding liquidity. The empirical framework was analysed and discussed according to the applied theories. It was concluded that, in particular after the Lehman brothers default there has been a heightened spreads in both markets. Thus, after the central banks interventions, there has been observed a more release in the market, though credit risk has been reduced along with the intervention of fiscal authorities. Thus, it is necessary to identify the underlying dynamics, in order to apply the correct tools to reduce the market turmoil.
Keywords: Turmoil in international interbank and FX swap markets, credit default risk, liquidity risk, funding risk central bank and fiscal authorities’ interventions.
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“George Bernard Shaw once remarked that the lack of money is the root of all evil. While this is clearly an overstatement, there have been periods, like the Great Depression of the 1930s, for which the statement rings true. But there have also been numerous episodes in history in which too much money as been the root of all evil”
- Lloyd B. Thomas
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Table of Content CHAPTER 1:INTRODUCTION...... 2
1.1 Problem statement...... 3
1.2 Delimitation & Assumptions...... 5
1.3 Definitions & Terminology...... 6
1.4 Choice of Method...... 8
1.5 Source Critic...... 9
1.6 Abbreviations...... 10
PART I
CHAPTER 2:THEORETICAL FRAMEWORK...... 12
2.1 Credit Risk...... 12
2.1.1 Credit Rating Agencies...... 14
2.1.2 Liquidity Risk...... 18
2.2 Covered Interest Parity...... 20
2.2.1 Covered Interest Arbitrage...... 20
2.2.2 Covered Interest Parity (CIP)...... 22
2.2.3 Equilibrium between Interest Rates and Exchange Rates...... 24
2.2.4 The FX Swap & Covered Interest Parity (CIP)...... 26
CHAPTER 3: Brief Summary of Events leading to the crisis in the Interbank and FX Swap Market. 28
PART II
CHAPTER 4:DESCRIPTIVE STATISTICS...... 33
4.1 International Interbank Markets...... 33
4.1.1 Brief Historic Introduction of the International Interbank Market...... 33
4.1.2 Liquidity Measures: Libor-OIS Spreads...... 37
4.1.3 Secured and Unsecured Spreads...... 41
4.1.4 Credit Measures: CDS Spreads...... 44
4.2 International FX Swap Markets...... 46
4.2.1 Liquidity Risk Measure- FX Swap Spread...... 48
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PART III
CHAPTER 5:EMPIRICAL ANALYSIS & DISCUSSION...... 52
5.1 International Interbank Markets...... 52
5.1.1 Factors triggered the Tension in Interbank Markets...... 52
5.1.2 Credit and Liquidity Risk...... 56
5.2 International FX Swap Markets...... 59
5.2.1 Turmoil Spill over of from the International Interbank Market to FX Swap Markets...... 59
5.2.2 Dynamics behind the Spill over to FX swap market...... 60
5.2.3 Dynamics behind the Deviations of the CIP in International FX Swap Market...... 62
CHAPTER 6:ANALYSIS AND DISCUSSION of the CENTRAL BANKS INTERVENTIONS...... 67
6.1 Overall Central Bank Measures...... 67
6.2 Overview of Central Bank Measures...... 69
6.2.1 Achieving the Official Stance of Monetary Policy...... 70
6.2.2 Influence Wholesale Interbank Market Conditions...... 76
6.3 The Effectiveness of the Term Auction Facility (TAF)...... 78
6.3.1 Effectiveness of the Swap Lines...... 84
6.4 Cooperation with Fiscal Authorities...... 84
6.4.1 Characteristics of government rescue packages...... 85
PART IV
CHAPTER 7:CHAPTER 7: PERSPECTIVE...... 88
CHAPTER 8:CHAPTER 8: CONCLUSION...... 91
CHAPTER 9:BIBLIOGRAPHY...... 95
APPENDICES
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CHAPTER 1: INTRODUCTION “ How could this happen? No one thought that the financial system could collapse. Sufficient safeguards were in place. There was a safety net: central banks that would lend when needed, deposit insurance and investor protections that freed individuals from worrying about the security of their wealth...” BIS (2008-79th): 4-5). This above stated quotation has been a concern for the whole world economy. As a result it has been announced that the world economy has been positioned in the worst recession, since the Second World War1 (Danmarks Nationalbank (2009): 1).
The deterioration in the US subprime mortgage sector that surfaced in the summer of 2007 rapidly spilled over to other segments such as the international interbank and FX swap markets. Since then the financial markets, in particular the core money markets have been characterised by turmoil (Danmarks Nationalbank (2008a): 11). Interbank markets are perceived as among the most important markets in the financial system, as they focus of central banks` implementation of monetary policy and have a significant effect on the whole economy (Allen and Carletti 2008): 1), while the FX swap markets one of the most liquid markets (ECB (2007): 26). As mentioned in the above quotation, given these features of these markets, the financial system collapsed. Poorly functioning money markets impinges on the availability and cost of credit to businesses and households, and expose the effectiveness of monetary policy (Taylor (2008): 2). It is therefore, essential to examine the underlying factors that have caused this dysfuntioning in these core markets, in order to be able to shelter from any similar future financial turmoil.
The paper is organised as follows. In chapter one, the problem statement, delimitation & assumptions, definition, abbreviation, source critics and methodology is presented. Chapter two presents the essential theoretical frameworks, and in chapter three a brief summary of events leading to the crisis that surfaced in the international interbank and FX swap markets. Chapter four describes the statistical data and basing the argument on the existing empirical literature, and chapter five represent the empirical analysis and discussion behind the underlying factors for the
1Economists identify these ”Big 5” crises since WW II (out of 18 total) Spain 1977: The first energy crisis affected Spain’s banking system, leading to 52% of 110 banks into serious problems. Norway 1987: Commodity- shock driven recession led to losses and the insolvency of banks: three largest banks nationalized. Finland 1991: Recessions preceded by financial market liberalization and the collapse of exports to the former Soviet Union led to a severe depression: the Finnish government spent over 10 billions Euros over the crisis period to support Finnish banks. Sweden: A restructuring of the tax system caused financial bubble that formed during 1980s to burst: the central bank unsuccessfully to defend the currency’s fixed exchange rate with the interest of 500% Japan 1992: Non-disclosure and a lack of transparency resulted in lower rating of Japanese financial institutions: thirteen Japanese financial institutions went effectively bankrupt during 1995 (Reinhart and Rogoff, (2008)).
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tension. Finally, chapter six analyse and discuss the central banks enrichments of the problem statement along with fiscal authorities’ interventions. Chapter seven contains the perspective and chapter eight the conclusion.
1.1 Problem statement “Financial crisis deepened in September 2008, liquidity in the interbank market has further dried up as banks preferred hoarding cash instead of lending it out..” Heider et al (2009): 1). As a resulted the turmoil “spilled over through the short-term foreign exchange (FX) swap market“ (Baba (2009): 24). Despite FX “markets appear to have increased in efficiency over time ... profitable arbitrage opportunities do tend to arise during periods of uncertainty and turbulence and may persist for some time before they are arbitraged away” (Taylor (1989): 386).
Lately, the lack of liquidity in the international interbank market has been a great discussion issue along with the financial crisis. In order to understand, the turmoil the international interbank market has been positioned in, and which spilled over to international FX swap markets, it is very essential to investigate what caused the financial system to break down to the extent it has in the time period of summer 2007 and 2009. Therefore, this paper aims to explore the factors behind the tension in the international interbank and FX swap markets and the central bank interventions that have occurred subsequently. This paper will cover the presented proposal, attempting to provide clear and coherent answers. This thesis follows the frame of the chronological major events of the financial turmoil beginning in the interbank market in the summer 2007, followed by the interventions of the central banks and thereby the spill over of the turmoil to the foreign exchange swap markets. The thesis is divided into four main parts, the first part of the paper will cover the theoretical framework of the effect of the turmoil in the interbank market. That is to identify the risks in the international interbank market that have prevailed the recent turmoil i.e. to investigate credit risk theory i.e. how many types of credit risks exist? “Given the important role of ratings in the investment and risk management processes, and in regulation, the turmoil has also raised questions about the effectiveness of credit rating agencies’ (CRAs’) assessments of risks in rating complex financial products” (BIS (2008): 1). Thus, it will be identified what the greatest three credit rating agencies? What are the rating categories presented by these credit agencies related to collateral and uncollateralised interbank instruments? On what reasons are the credit ratings based on?
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Moreover, what is liquidity risk? What are the types of liquidity risk in the financial markets? And what are underlying factors liquidity risk depends on?
Furthermore, the thesis will bring light to the theoretical framework of the FX swap market. It will analyse what the covered interest arbitrage and what covered interest rate parity condition (CIP)s are ? Furthermore, it will examine the link between the CIP and the FX Swap markets.
The second main object of the thesis is to describe the problem statement with possible statistical data explanation factors behind the tension observed in the international interbank and FX swap markets. Therefore, the first part of the second main part of the thesis, initially intends to describe the fundamental characteristics of the international interbank markets. What is the interbank market? How does this market function? Thereafter, the development in the international interbank through measures reflecting the theoretical framework i.e. how did the Libor-OIS spreads, secured and unsecured spreads along with term rate spreads, credit default swap (CDS) spreads developed in the US interbank market, European interbank market, UK interbank market and (Japanese market), during the time period of 2007-2009.This will be followed by a description of the FX swap market i.e. what is the FX swap market? How does the FX swap market function? And again the development of the FX swap implied dollar rates.
The third part of the thesis will empirically analyse and discuss the statistical data observed in the second main part, in the light of the applied theories. What triggered lack of liquidity experienced in the international interbank market? What was the relation between the interbank market and the liquidity facilities of the central banks? What were the underlying dynamics behind the tension in the international interbank markets? Again, what triggered the spill over to the FX swap market? What was the underlying reason behind the FX swap spread i.e. deviation of covered interest parity (CIP) observed in part two. Furthermore, there will be an investigation of the central bank responses along with fiscal authorities’ interventions during the financial turmoil in the international interbank and FX swap markets. What have the main central banks implemented as a response to the financial crisis? Have these actions been able to eliminate the tensions observed in part 2 i.e. credit and liquidity risk? Why have governments intervened in the crisis? What are the most remarkable actions by these governments?
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And finally, the fourth part of the thesis presents the perspective and the conclusion. There will be a review of how to weather such a future financial crisis in the international financial markets through new regulations.
1.2 Delimitation & Assumptions The Analysis of the tension in the international interbank and foreign exchange (FX) swap markets presented in this paper is based on certain assumptions and certain factors which are delaminated, that are discussed below. Though, assumptions and delimitation can also occur through the paper, where it is seen necessary for the sake of a more clear understanding. This paper is founded primarily on the most severe effected markets/currencies in the G-10 markets i.e. the US dollar, Euro, Sterling markets. This relies in the reasoning of extended available information on these groups as recent major researches have been conducted in this study area (Michaud & Upper (2008): 47); Baba et al (2008): 74); ECB (2009-1025): 9-11). Hence, order to give a better understanding comparison to other markets such as the Asian markets i.e. Japanese market can/will occur to present a more accurate picture of the effect of the international money markets and FX swap markets. However, technicalities and legal niceties will not be elaborated and therefore ignored in this thesis (Stigum (2007): 1101). Moreover, in this paper, banks are used as a generic term for the central banks` counterparties (Danmarks Nationalbank (2008-1): 42). The central banks that will be referred to in the thesis will be mainly Federal Reserve Bank, European Central Bank, and Bank of England. Hence, in order to give a more comprehensive visual rendering of the global financial turmoil, other central banks that have played a central role in the crisis will also be included i.e. for instance the Swiss National bank, Bank of Japan, and Bank of Canada. Interbank markets are subjected to a wide array of risks in the course of their operations (Grabbe (1996): 227). In general, banking risks fall into four categories i.e. financial, operational, business and event risks. Financial risks comprise two types of risk i.e. pure risks and speculative risks. First, pure risks, includes liquidity, credit and solvency risks, and secondly speculative risks, which involves interest rate, currency and market prices risks (Van Greuning (2003): 3). Given that the interbank market is also involved in foreign exchange, as well as ordinary time deposit rates etc. it is also exposed to credit, currency, and liquidity risk as in general banking (Gallanis (2009): 61). Hence, as the main subject of this paper is to investigate the credit/liquidity risks in relation to the global financial crisis in the international interbank and FX swap markets, this paper will solely focus on credit and liquidity risk. The other mentioned risks will not be delimitated due to the scope
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of the paper and limited paper size. Furthermore, there will solely be focus on the greatest three external agencies i.e. S&P`s, Moody`s and Fitch, and their short term credit ratings, as this paper simply investigates the short term international money markets (Crouhy (2001): 261); Ashcraft & Schuermann (2008): 37-38).
As the aim of the paper to investigate the short term international interbank markets, thus, in this paper, solely instruments with maturities within one year. Those that will be included are issued by financial corporations and governments to obtain short term funds (Madura (2000): 125). These instruments are further characterized by “high liquidity and relatively low default risk” (Lloyd (1997): 52), which is a quite important aspect for the recent financial turmoil in the international money markets. These instruments will further be distinguished between unsecured and secured instruments, where unsecured instruments that will be included is interbank loans, and secured instruments as bankers repurchase agreements (repos) (OECD (2007): 492). Furthermore, as a FX exchange instrument, there will solely be focus on FX swaps Baba et al. (2008), which also are secured instruments due to the international aspect of the paper (Mehlbye & Topp(1996) :49).
1.3 Definitions & Terminology In this subsection, the various definitions used in the paper will be presented, in order to eliminate any ambiguity that could rise due to differences in terminology. Covered Interest Parity Condition: In the literature, there has been a mixture of use of the covered interest (rate) parity condition (Peel and Taylor (2002): 52); Keynes (1923): 103-104); Eaton and Turnovsky (1983): 555), while other authors have used the term interest parity condition, which also is the non arbitrage condition, to describe the latter David et al. (1998); Hilley (1979: 99); Tsiang (1959): 81) as it is assumed it is covered. Therefore, in this thesis both of the terms are consistently applied with the objective of explaining the same condition.
International Money Market: Levinson (2005) emphasises that there exists no precise definition of the money markets but the phrase is usually applied to the buying and selling of short term debt instruments. The money market is further described as a network of corporations’ i.e. financial institutions, investors and governments which deal with the flow of short-term capital 2 (Levinson (2005): 38-39), Madura (2000): 2); Lloyd (1997): 52). Money market instruments are issued when
2 That is when businesses need cash for few months until a great payment arrives, or when a bank wants to invest money that depositors may withdraw at any time, or when a government tries to meet its payroll in the face of large seasonal fluctuations in tax receipts, short term liquidity transactions (Levinson, Marc (2005): 38-39), (Jeff Madura (2000): 2).
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ever experienced a temporary shortage of cash, and due to the fact that money markets serve businesses, the average transaction size is very large (Madura (2000): 137). There are several types of money market instruments3 which are issued in the primary market4 by corporations and governments to obtain short term funds through sale in the secondary market (Madura (2000): 125), (Levinson (2005): 42). One of the very important instruments is interbank loans, which are traded in one of the money market segment called interbank market.
OECD (2007) defines the international interbank market as the following; “The international interbank market is an international money market in which banks lend to each other – either cross-border or locally in foreign currency – large amounts of money, usually for periods between overnight and six months” (OECD (2007): 411). The definition created by OECD will be applied as it defines it clear and sharp, and the aim of this thesis to investigate the international interbank market due to the detected recent turmoil in there. In the thesis the term interbank market is applied as international interbank market, except an explicit interbank market is given. Thus, the short term instrument maturities can be extended to 12 months.
Collateralized Debt Obligation (CDO): A CDO is a type of asset backed security, a financial tool that repacks individual loans into a product that can be sold on the secondary market. The portfolio of the underlying of the CDO can consist of bank loan, corporate bond etc. CDO`s are called asset- backed commercial paper, if the package consists of corporate debt, and mortgage backed securities, if the loans are mortgages. If the mortgages are made to those with a less than prime credit history are called subprime mortgages (Plesner (2005-2).
Forward exchange rate: The forward exchange rate in this paper will be expressed as the unit price in local currency of foreign exchange bought or sold for future delivery. While the forward premium (or discount when negative) is to be understood as the discrepancy between the forward and spot exchange rates as percentage of the spot exchange rate (Tsiang (1959): 76).
Liquidity ”is easier to recognize than to define” (BoF (2008): I). Various authors have defined this notion. Very broadly, liquidity has been defined as ability of payment, or more accurately defined by the Federal Reserve Bank as the “The capacity and the perceived ability to meet known near-
3 See Appendix 1, for the most known money market instruments. 4 The primary market is referred to the initial offering of a security i.e. whether a stock, a bond, a loan, or a derivative instrument. While the secondary market refers to the market where existing securities can be traded between investors (Arvind (1994): 166).
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term and projected long-term funding commitments while supporting selective business expansion in accordance with the bank´s strategic plan” (Plesner (2008): 4); Basel Komittee (2000): 1). Yet, BIS (1999), also highlights and defines a liquid market as a market where participants can quickly execute large volume transactions with a small impact on prices (BIS (1999): 5); BoF (2008): I).
The referred European System (of Central Banks) consists on the European Central Bank (ECB) and the national central banks of the European Union member states. It is to be noted that the national banks of those Member States, which have not adopted the single currency in accordance with the Treaty establishing the European Community are not involved in the conduct of the single monetary policy, due to retain in own monetary policy according to national law (ECB (2008t): 7).
1.4 Choice of Method The thesis intends to assess the underlying dynamics behind the turmoil in the international interbank and FX swap markets. The thesis is a theoretical paper nevertheless relevant available empirical studies will be incorporated, order to enlighten the theoretical framework from a practical point of view.
In order to create a connection between the tension experienced in the international interbank and FX swap markets, credit and liquidity risk theories and the covered interest rate parity theory will be reviewed. The academic literature on credit risk has grown substantially over the last decades. Modern techniques and models5 have been developed to assist financial intermediaries, corporate and investors to better price and manage the credit risk exposure they are facing. Yet, in this thesis, these major models will not be touched further as it is out of the scope of this paper. Hence, credit risk presented by Bank of International Settlement, Gallanis (2009), and Horcher (2005) will be described with the simply aim of enlightening the effect of the credit risk on the international interbank and FX swap markets. Simultaneously, liquidity risk theory presented mainly by Brunnermeier & Pedersen (2008), Plesner (2008), and Bank of International Settlement will be review. Whereas, the analysis of the foreign exchange swap markets is based on the covered interest
5 Three main approaches to analyzing credit has been presented i.e. the structural, reduced form and incomplete information approaches (Fabozzi, (2005): 780). The structural credit models, goes back to the Black and Scholes and Merton (1973) which relied on the use of the option theory framework to model the value of the equity of the firm and corporate debt. The market value of the firms appears as an essential source of uncertainty driving the credit risk (Fabozzi.(2005): 780). The other line of literature involves the alternative for modeling credit risk from the structural approach is the reduced form. Jarrow & Turnbull (1995) and Duffie and Singleton (1999) have presented two recognised models under this framework (Jarrow & Turnbull (1995):53), (Duffie and Singleton (1999): 687). In this approach, the reason behind the default of a firm is not answered, but instead the dynamics of default are given exogenously through a default rate. The third approach combines the structural and reduced form model, where avoiding the two other approaches difficulties, it chooses the best features of both approaches. I.e. the economic and intuitive appeal of the structural approach and the tractability and empirical of the reduced from approach. In this approach, prices of credit-sensitive securities can be calculated as if they were default-free using an interest rate that is the risk free rate adjusted by the intensity (Jarrow & Turnbull (1995):54).
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rate parity (CIP) set forth by Keynes (1923) in his Tract on Monetary Reform, and further elaborated by Tsiang (1959).
Each of these two markets will be described and the development of the tension will be described in the following measures; Libor-OIS spread, secured and unsecured term rates, CDS spreads and FX swap implied dollar rates will be described, which aims to connect the theoretical frameworks with the statistical data available, as the theories will be reflected in these measurements. Furthermore, in the fourth part of the thesis there will be a discussion of the underlying dynamics behind the measurements in the light of the applied theoretical framework. This will be followed by an analysis of the central banks actions and the effectiveness of the applied interventions along with the fiscal authorities.
1.5 Source Critic Due to the nature of the study subject i.e. to analyse the international interbank market and the financial turmoil it is weathering, it is quite important to gather as much information as possible to be able to give a fair portrait. Thus, this paper is founded on a great range of litterateur which is financial, economic and empirical. Moreover both international and Danish litterateur will be applied to illustrate various perspectives as possible, in the frame of the problem statement. Moreover, it has to be stated that a major part of the data is extracted from Bloomberg6, and Aarhus school of Business do not have access to this website, therefore, the major set of data collected is from sources such as prominent authors that have engaged in the field and major central banks, as European Central Bank, Federal Reserve Bank, Bank of England, Bank of France stability reports, and bulletins Therefore, the applied sources are perceived to be highly reliable. The judgements on the data are based on the latest possible sources after examined carefully and compared to the majority of the data due to clear and cohort answers. Hence it cannot be rejected that the data applied are based on various time zones, and do not cover exactly the time frame from the second half of 2007, and until 2009 due to limited availability. It should be noted that while every effort has been taken to make this paper as accurate as possible, changes in statistics, legislations or other factors may mean that some variation could occur and a result of this it may not be very comparable.
6 This has been confirmed by Mr. Naohiko Baba and Christian Upper with an email, stating that Bloomberg has been a key source of origin in data collecting, both for Libor-OIS, CDS, and FX swap implied dollar rates spreads applied in chapter 4. (Baba (2009): 18 August); Upper (2009): 18 August).
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Additionally, both empirical and other articles/publications that enlighten the study subject are applied. Concerning the empirical articles/publications applied, there has been attempt to rely on authors who have specialised in the subject range. Others have been selected based on the publishers who are perceived to be trustworthy. Moreover, press releases with prominent characters associated with the problem statements is also attempted to be applied. These are found from websites, which are assessed credible. In the selection of empirical studies, it has been crucial whom the studies have been conducted by. Thus, there have been applied empirical studies also made by the above mentioned central banks, as many have been conducted by these as well, as it is crucial for the problem statement of this paper. However, the selection criteria for the studies have been based on latest time being, at the same time as could enlighten the theoretical frameworks from a more practical point of view. It cannot be redundant that some of the empirical studies have been conducted on different time frames, which will of course not give the same comparison basis for the applied empirical data. The data and years will be mentioned on every occasion it is seen relevant.
1.6 Abbreviations ABS Asset-Backed Securities ABCP Asset-Backed Commercial Paper BIS Bank for International Settlements BoC Bank of Canada BoE Bank of England BoJ Bank of Japan CDO Collateralised Debt Obligations CIA Covered Interest Arbitrage CIP Covered Interest Rate Parity ECB European Central Bank Fed Federal Reserve FOMC The US Federal Open Market Committee FX Foreign Exchange RBA The Reserve Bank of Australia MBS Mortgage-Backed Securities SIV Structured Investment Vehicle SNB The Swiss National Bank TSLF Term Securities Lending Facility PDCF Primary Dealer Credit Facility
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CHAPTER 2: THEORETICAL FRAMEWORKS There exist various reasons for the spill over effect of the turmoil to the foreign exchange swap markets, initiating from the interbank market. Therefore, this section aims to cover the theoretical aspects of the effect of the turmoil initially detected in the interbank market i.e. the credit- and liquidity risk theories, which will be the basis for the second part of the theoretical framework. The second part of the first part of the paper will bring light to the theoretical framework of the FX swap market i.e. the covered interest arbitrage condition (CIA) and covered interest parity condition (CIP), and the relation to the FX swap market.
Part I: Interbank markets are subjected to a wide array of risks in the course of their operations (Grabbe (1996): 227). Financial risk is one of these risks mentioned above and comprise of inter alia pure risks, which includes liquidity and credit risks. (Van Greuning (2003): 3). According to several authors, given the nature of the interbank markets, this market is exposed to credit and liquidity risk as in general banking (Gallanis (2009): 61). Thus, this chapter aims to give a description of the theoretical framework of credit and liquidity risks which have played central roles in the recent financial turmoil identified in the international money markets.
2.1 Credit Risk “ Would you lend your money to this?” This hoary question has been asked by loan providers, investors, and credit analysts all over the world as an assessment of the commitment of the one (Ganguin, Blaise (2004): 17). Every business face credit risk as it exists whenever payment or performance to a contractual agreement by another entity is expected, and it is the likelihood of a loss arising from default or failure of another entity. Credit risk is defined as the “Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms” (BIS (1999): 1); Reto (2003): 130); Banks (2004): 6). In particular, financial institutions generally have considerable credit exposure due to their prominence on lending and trading (Horcher (2005): 103), and the international interbank market is not an exception. According to Aikman (2008), interbank markets are subject to types of risk i.e. borrower default and market risk, which will be discussed in details below (Aikman (2008): 8). According to Anson et al. (2004) credit risk is specified as three types of risk i.e. default, downgrade and credit risk (Anson et al. (2004): 4).
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Default Risk: Horcher (2005) stresses that, traditionally, credit risk is associated with lending, investing, and credit granting activities and concerns the return of borrowed money. However, a great source of credit risk in financial markets arises from the performance of counterparties in contractual agreements e.g. given a financial obligation, which is not fully discharged, either due to the counterparty disability to fulfil his or her obligations which may result in a loss. In the literature, these credit risks are referred to as counterparty risks since they arise from transactions with counterparties (Horcher (2005): 104-7).
Yet, according to Anson et al. (2004) counterparty risk is defined as default risk, where the issues of a bond or the debtor on a loan would not replay the outstanding debt in full. Default risk can be complete given that no amount of the bond or loan would be repaid or partial, given that some part of the original debt would be recovered (Anson et al. (2004): 23). The likelihood of the default occurring is recognised as the probability of default. The likelihood of a recovery depends on several factors as well as the legal status of the creditor, hence if an institution fails due to large outstanding obligations or losses, later collections may be difficult or impossible (Horcher (2005): 104-5). Downgrade Risk: In order to estimate the default risk, investors rely on credit analysis conducted by nationally recognised statistically rating firms, which express their estimates in the form on credit rating7 (Anson (2004): 23). The following subsection will further elaborate on the main three credit rating agencies. Downgrade risk is thereby defined as the risk that a recognised rating firms such as Standard & Poor`s, Moody’s Investors Services, or Fitch Ratings reduces its outstanding credit rating for an issuer based on an evaluation of the current earning supremacy of the issuer in opposition to its capacity to repay its debt obligations as they become due. An improvement in the credit quality of an issue or issuer is rewarded with a superior credit rating, referred to as an upgrade, whereas a weakening is referred to as a downgrade (Anson (2004): 4).
The consequences of a downgrading of a credit rating will depend on the following circumstances; the market price of the debt securities will fall, and thereby investors will suffer a loss. If the issuer prepares to issue more debt securities, investors will demand a higher rate of interest to compensate for the higher risk. In some situations, the issuer may agree to a condition whereby the interest
7 Although credit ratings are provided for the benefit of investors, the issuer bear the cost involved as it is the interest of the issuer to request a rating as it raises the profile of the issue of debt capital, and investor may refuse a purchase that is not accompanied with a recognised rating. In theory, credit rating is not applied to an organisation itself, but to a particular debt security that the firm has issued. Hence, in general practice it is common for the market to refer to the creditworthiness of firm itself, in terms of the rating of their debt. E.g. a highly rated firm may be referred to as a “triple A rated”, although it is the debt issues of the company that are rated as triple A (Anson (2004): 23).
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payable on the securities to be raised if their credit rating is downgraded to or below certain level (Coyle (2002): 134).
Credit Spread Risk: A credit loss may occur i.e. the credit standing of the issuer is perceived by the market to have diminished. The market will subsequently require an interest rate premium i.e. a higher credit spread) to cover the higher credit risk forcing the security price to drop. A wider credit spread could also reflect the perception of the market that the return on a security with a given credit quality must be higher, e.g. in association with a repeated downturn (Danmarks Nationalbank (2003): 96). Therefore, credit spread risk is the risk that the spread over a reference rate would increase for an outstanding debt obligation. The difference between credit risk and downgrade risk is that the latter concerns a particular formal credit review by an independent rating agency, whereas the former is the reaction to perceived credit weakening of the financial markets (Anson, Mark (2004): 5-6). Horcher (2005) presents various factors that could be presented as an explanation for this disability i.e. poor economic conditions, high interest rates, or when an organisation has accumulated large losses, owes many other counterparties, or when a creditor or counterparty of an entity face financial difficulty or failure (Horcher (2005): 103-4).
2.1.1 Credit Rating Agencies “ Given the important role of ratings in the investment and risk management processes, and in regulation, the turmoil has also raised questions about the effectiveness of credit rating agencies’ (CRAs’) assessments of risks” (BIS (2008): 1). If someone is willing to invest their own money, then they would most probably have conducted a full due diligence analysis, screening all assumptions and verifying the related facts. Anyone who has the responsibility for lending the money of an institution to another institution should have the same level of analytical commitment. Information is often varied and imprecise, it is preeminent to have on a tight rein and systematic approach to the task (Ganguin (2004): 17). Nevertheless for this reasons credit rating agencies have achieved a vital function as credit risk is dealt with in the interbank market by establishing limits on the amount of dealing with a bank according to the overall reputation of the bank in the market (Grabbe (1996): 230).
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The Basel Committee8 has become gradually prominent in setting capital adequacy guidelines for banks internationally. In the beginning of 2008, many countries officially adopted Basel II9. As a result, the significance of the fundamental credit analysis of financial institutions, the main credit agencies strive to provide research to light up the features and ramification of Basel II (Fitchrating (2009); Standard & Poor`s (2009); Moody`s (2009)). Today, the three large credit-rating agencies are Fitch10, Moody`s11 and Standard and Poor`s12 and are regarded as unbiased evaluators. Their ratings are widely accepted by market participants and regulatory agencies (Danmarks Nationalbank (2003): 92); Michel (2001): 262). At the end of 1997, the number of rated firms was recorded to be 4,000 through the world (Andersen, et al. (1998): 40), and today, there exists more than $80 trillion of rated securities (Moody`s (2009)).
Methods of Credit Risk Assessment Credit assessments take time and require specialist skills for credit analysts. Large institutions rely on such specialist to carry out credit analysis, however, too often it is too costly and time consuming (Coyle (2002): 132); Andersen et al (1998): 1). According to Coyle (2002), for that reasons investor usually employ two methods when making decisions on the credit default risk of debt securities i.e. 1) name recognition and 2) formal credit ratings. Name recognition is when the investor relies on the good name and also the reputation of the issues and accepts that the issuer is of sufficient financial standing, that a default on interest and principle payments is highly unlikely (Coyle (2002): 133). Hence, it is to be noticed that name recognition needs to be improved by other methods to reduce the risk against surprising events13. A credit rating is a formal outlook offered by a rating agency of the credit default risk faced by investing in a particular issue of debt securities14. Note that a rating never constitutes a recommendation of the liabilities of a given issuer or borrower, and rating should always be used
8 In 1970, G-10 countries established the Basel Committee, which is perceived as the central bank Governors of the Group of Ten countries (Danmarks Nationalbank (2004): 1). 9 In 1980 the Basel Capital Accord was published and implemented between 1988 and 1992, it was the first attempt of the committee to standardize the way banks measure and report capital adequacy. In 1999, the committee published an improved methodology and measurement of capital in The New Capital Adequacy Framework, this renamed Basel II (Fitchrating (2009). 10 On 24 December 1913, Fitch Ratings was founded as the Fitch Publishing Company by John Knowles Fitch. Fitch Ratings was one of the three ratings agencies first recognized as a nationally recognized statistical rating organization (NRSRO) by the Securities and Exchanges Commission in 1975 (www.Fitch.com (2009). 11 In 1900, John Moody started its business as the John Moody & Company Published Moody`s Manual of Industrial and Miscellaneous Securities, which pioneered the Moody`s Rating as known today (moodys (2009)). 12 S&P`s is traced back to 1906, where the Standard Statistics Bureau was formed to provide financial information on U.S. companies (www.s&P.com (2009)). 13 In 1995, the British bank Barings suggested investors that relying solely on name recognition was not such a healthy decision in the marketplace of today. The tradition and reputation behind the Barings name allowed the bank to borrow at LIBOR or seldom at subLibor interest rates in the money market, which made it on par with the highest quality banks in terms of credit rating (Anson et al. (2004): 23). 14 Ratings are given to public issues of debt securities by any type of entity, including governments, banks and corporate (Coyle (2002): 132).
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subject to the investor or borrowers own liability and risk (Andersen et al. (1998): 1). Credit rating, for long term debt obligations, is a forward looking assessment of the probability of default and the relative scale of the loss should a default occur. For short term debt obligations, a credit rating is a forward looking assessment of the probability of default (Anson et al. (2004): 23); Michel (2001): 262-63); Deacon (2004): 13). Hence, as this paper is solely focusing on short term securities, the focus would only be relied on the credit ratings for short term debt obligations.
Purpose of Credit Ratings Scoring systems to rank credit risk with grades achieves several goals, where analysts can benchmark credit quality across firms from various countries and sectors. As credit rating will affect the interest rate at which entities can issue new debt securities, or even whether they will be able to issue new debt securities, the purpose of the credit rating is to give investors a repayment of the debt principle on time.
Investor can use this information in several ways as to refuse to buy the security with a credit rating below investment grade, or below a specific investment grade. Furthermore, such ranking provides an indication of the investment premium that would be required for a particular level of risk, assuming in efficient markets, the higher the risk is, the higher and the reward will be and/or sell securities from their investment portfolios whose credit rating is downgrades below certain level (Coyle (2002): 139). Additionally, a credit ranking system is seen as a robust analytical framework, which provides an excellent tool for monitoring the evolution of credit risk over time. Moreover, institutions need to assess the recovery prospects for distressed debt, in particular during recession, when a part of their portfolio is impaired. Referring to the introduction of this chapter, “Would you lend your money to this?” (Ganguin (2004): 17) given the described assessments, loan providers would have to some extent guaranteed their worries i.e. if there is sufficient likelihood of the borrowed money to be paid back on time, presented in this old-question. Yet, drawing on these inputs, BIS (2009) emphasise that credit rating information should support, not replace, investor due diligence (BIS (2008): 1). The greatest rating agencies mentioned above, apply separate categories for each short term debt15, which is illustrated in Table 116 that express their assessment of the outlook for compliance with the payment obligation.
15 While, similar symbols are used for long term rating systems of the rating agencies, however, this will not be illustrated here as it is out of the scope of this paper (Anson et al. (2004): 25). 16 See Appendix 2, for the ratings.
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Factors Considered in Rating There are various factors rating agencies considered when representing their ratings. Anson et al. (2004) describes these as the four Cs of credit i.e. character, capacity, collateral and covenants. The first C includes the foundation of sound credit i.e. the ethnical reputation as well as the business qualifications and operating record of the board of directors, management, and executive responsible for the use of the borrowed funds and repayment of those funds. For instance, Moody´s try to understand the business strategies and policies formulated by the management. They further analyse the strategic direction, financial philosophy, conservatism, track record, succession planning, and control systems etc. The second C considered in rating is the capacity or the ability of an issuer to repay its obligations, whereas the next factor considered is collateral, where it is assessed whether the assets guarantee to the debt and the debt holder. Here Moody`s, analyses the financial statement of the specific firm17. The last factor considered is the covenant condition of the lending agreement. Covenants mirror restrictions on how management functions the company and conducts it financial affairs. A default or violation of any covenant may carry great weight as an early warning enabling investors to take actions before the situation deteriorates further. Therefore, covenants play a significant role in minimizing risk to creditors as it assist prevent unconscionable transfer of wealth from debt to equity holders (Anson et al. (2004): 25-27); Michel (2001): 262-63).
A very crucial element to emphasise is that in the international money market, credit risk is not the only risk faced by participants but currency risk also plays a vital role due to the involvement of foreign exchange rates etc. (Grabbe (1996): 227). According to factors considered in rating, it is noticeable that currency risk has been ignored in credit rating analysis (SFRC (2007): 4). Furthermore, in general, swap arrangements also involve credit risk i.e. the credit risk to a dealer is the possibility the counterparty of the dealer may default when the value of the swap to the dealer is positive (Grabbe (1996): 331). Thus, the following sub-chapter aims to describe the effect of the turmoil to the foreign exchange swap markets from a theoretical framework.
17Other factors examined by Moody`s are for instance, industry trends (here it is examined the vulnerability of the company to economic cycles, the barriers to entry, and the exposure of the company to technological changes), regulatory environment, basic operating and competitive position, financial position and sources of liquidity, company structure, parent company support agreements, and special event risk (Anson et al. (2004): 27).
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2.1.2 Liquidity Risk A well functioning money market is very important, in order to ensure that financial market participants can adjust their liquidity positions and to provide funds for growth (BIS (2007t): 1); Van Greuning (2003): 167). Liquidity risk is defined as the risk of insufficient liquidity funds on hand to meet obligations i.e. the ability of the bank to meet its liabilities when they fall due (Heffernan (2005):105); Van Greuning (2003): 168); Horcher (2005): 44); OECD (2007): 449). This is a quite important element in the interbank market trading with short term instruments where day to day operations is required to sustain the activity in international interbank markets. In day to day operations, the management of liquidity is usually achieved through the management of the assets of the bank. While in the medium term, liquidity is also addressed through management of the structure of the liabilities of the bank18 (Van Greuning (2003): 168); OECD (2007): 449); BIS (2009abc): 243).
In the literature it is distinguished between two types of liquidity risk i.e. funding risk and market liquidity risk (Plesner (2008): 4). Funding risk is defined as risk of insufficient or (prompt) liquidity funding of the bank to meet its liabilities. Funding risk is further composed into refinancing, time and call risk. Refinancing risk is defined as the possibility that a bank will not be able to refinance existing maturing deposits, liabilities etc. while, time risk is the negative liquidity effect of defaulting payments from the asset site e.g. due to defaults in lending portfolio and call risk, is the risk due to difficult predicting of liabilities related to derivatives, liquidity facilities, and other off balance sheet activities. Market liquidity risk is the inability of a bank/firm to realize assets without a sizeable loss due to lacking market depth19 (BIS (1999): 5); Brunnermeier & Pedersen (2008): 1-2); Plesner (2008): 5); BoF(2008): I). It is noteworthy to stress that both funding and liquidity risk are nearly related as a bank/firm may be obligated to realize assets on a bad time, in order to obtain funds to redeem obligations. Plesner (2008) stresses that, at worst a negative feedback loop can occur between these types of risk. I.e. an initial decrease on the price of the asset can lead to margin calls20, which can only be met trough rummage sale of assets, which not surprisingly fall further in prices, which
18 Liquidity risks are, in general, managed by the asset-liability management committee (ALCO) of the financial institution, which requires an understanding of liquidity and other market, and credit risk exposures on the balance sheet (Greuning (2003): 168-169). 19 Usually, market liquidity is considered according to at least one of three possible dimensions: tightness, depth and resiliency. Tightness is how far transaction prices diverge from mid-market prices, and can generally be measured by the bid-ask spread. Depth indicates either the volume of trades possible without affecting prevailing market prices, or the amount of orders on the order-books of market-makers at a certain time. Resiliency refers to the speed with which price fluctuations resulting from trades are dissipated, or the speed with which imbalances in order flows are adjusted (BIS (1999): 5). Hence, this will not further be elaborated on, as this part aims to give a brief description of the market liquidity risk, in order to enable explaining the effect on the international money market. 20 A demand for additional funds because of adverse price movement.
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restarts the margin call again. Generally, all types of institutions are exposed to liquidity risk, hence in particular interbank markets, which have an intermediary role, and thus exposed to a higher extend. As the broader financial systems along with the economy of the world are strongly dependent on the core money markets meet their function as supplier of liquidity (Plesner (2008): 5); BoF (2008): 22). It is not a secret that the effect of the turmoil in the international interbank market has been the main reason for the scale of the financial turmoil as it is the heart of the whole financial system. Therefore, a sound stability in the international money market is a crucial subject.
Factors Liquidity Risk Depends On The liquidity and liquidity risk of a bank depends generally on internal as well as external factors i.e. the balance sheet structure, financial soundness, market access of the bank, and market development. The balance sheet structure21 of a bank is an outcome of sequence of business decisions, where the goal is to maintain the highest possible marginal rate. Conventionally, core deposits are perceived as the most stable funding source. Core deposits include ordinary demand deposits and other types of deposits. Almost all these types of deposits are guaranteed by some sort of deposit guarantee scheme and an implicit liquidity guarantee from the “lender of last resort”.
Due to demand of money, there will be daily in-and-out transactions of these deposit, however, as long as there is a trust to the bank and the banking system is steady, the bank will have an average deposit level as a permanent and cheap funding source. The financial soundness of a bank is the ability of making a profit, which is vital for the possibilities of obtaining funding through more volatile funding sources such as interbank markets. In this market, the lender is not protected by (explicit) guarantees, and therefore it would demand a compensation for the risk involved through credit spreads. A degradation of the soundness of the bank or a general decrease of creditors risk tolerance would immediately be mirrored in the spreads and thereby make it more expensive to or in the worst case, make it impossible to borrow. The market access of the bank is vital to obtain funds through capital markets, e.g. issuing bonds, or asset backed securities (Plesner (2008): 5-6).
Hence, a very essential subject to call attention to is that liquidity risk is interrelated with the credit risk, as given a high credit risk may imply and thereby result insufficient funds to meet day to day operations, as a result of decline in confidence among investors. BIS (2007t) also underscore that a
21 See Appendix 3, for Balance Sheet Structure & Liquidity Risk for banks
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loss of liquidity in a money market generally has more serious effects than a loss of liquidity in markets for longer term instruments, due to the large amount of money market instruments become due each day. Furthermore, developments in the global financial markets have highlighted that given pressure on liquidity and balance sheets, combined with heightened credit concerns, made banks reluctant to provide others with term funding22 i.e. interbank market loans with terms longer than overnight (BIS (2007t): 2).
Part II: “A much less well documented aspect of the turmoil is how the turbulence in money markets (in particular interbank markets) spilled over to foreign exchange (FX) swap markets” (BIS (2008): 3). Therefore, this part will cover the theoretical framework of this spill over via the covered interest parity and its relation to the FX swap market, the deviation of the CIP.
2.2 Covered Interest Parity The traditional theory of forward exchange was set forth by Keynes in his Tract on Monetary Reform, which mainly concerned about the possibility of interest arbitrage. Thus, this was further elaborated on the forward exchange market by Sohmen (1961, 1966) and Tsiang (1959). Therefore, the following theoretical presentation initially describes the covered interest arbitrage presented by Sohmen (1961, 1966) and Tsiang (1959), followed by the covered interest parity condition and its relation to the FX swap market.
2.2.1 Covered Interest Arbitrage Even in the 1800s there was evidence of foreign exchange traders engaged in covered interest rate arbitrage (Peel and Taylor (2002): 52-53). According to anecdotal evidence suggested by to Lotz (1889), Raffalovich (1895), Schulze-Gaevernitz (1899), Haupt (1892), Margraff (1904) covered interest rate arbitrage was indeed common in both in Europe and in the United States, but the activity in forward exchange operations, in general become much more intense in the interwar floating rate period (Keynes (1923): 102) ; Einzig (1937), (1962): 171, 235); Peel & Taylor (2002): 52-53). Tsiang (1959) emphasises that short-term funds tend to flow from one centre to another e.g. from dollar money market to pounds sterling money market, if the rate of return in one money market is
22The bankruptcy of Lehman`s, mid-September 2008, caused a complete collapse of confidence in the financial health of money market counterparties. This resulted in banks hoarding liquidity, interbank rates climbed to historical highs (2008d): 9-11). Hence, this will further elaborated on chapter 5.
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higher than that in the other, after the risk of exchange fluctuation is eliminated by a forward exchange transaction in the opposite direction (Tsiang (1959): 78-79). In other words, if the interest rates are higher in the domestic country than in the foreign country, then the currency of the foreign country would be selling at a premium in the forward market, while if interest rates are lower in the domestic country, then the foreign currency would be selling at a discount in the forward market 23 (Grabe (1996): 106). The notation for the formulation above is as the following;
Where St represents the domestic currency price of foreign currency in the spot market at time t, Ft
d is the price of foreign currency deliverable forward at time t, i t it is the domestic interest rate at
f time t and in i t is the corresponding interest rate abroad at time t. The proposition states that short-term funds would tend to flow from dollar money market to
f d pounds sterling money market if Ft / St (1+ i t) > (1+ i t) (1) On the other hand, funds would tend to be transferred from pounds sterling money market to dollar
f d money market, if Ft / St (1+ i t) < (1+ i t) (2)
d Given $100 invested for three months in US money market would be $100 *(1+ i t), and if the same amount in dollars is converted into sterling at the current spot rate and invested for three months in UK money market and then converted back into dollars at the current forward rate for sterling for
f three months delivery, it would become If 100$ x Ft / St (1+ i t).
f d If 100$ x Ft / St (1+ i t) > $100 *(1+ i t), arbitragers would gain a net profit by a temporary transfer of funds from dollar money market to pounds sterling money market, whereas if
f d 100$ x Ft / St (1+ i t) < $100 *(1+ i t), the net profit would be gained by a transfer of funds from pounds sterling money market to dollar money market. Figure 4.1 describes the steps that an arbitrager would implement to perform a CIA transaction. Figure 4.124, illustrates the conditions
f d where 100$ x Ft / St (1+ i t) > $100 *(1+ i t) and for the other condition where
f d 100$ x Ft / St (1+ i t) < $100 *(1+ i t) it would have been the other way around i.e. transfer of funds from pounds sterling to dollar money market instead of from dollar to pounds sterling money market.
23E.g. if interest rates are higher in US than in UK, then the forward pounds sterling would cost more US dollars than will the spot pounds sterling. The forward pounds sterling will be at a premium and the forward dollar at a discount. If interest rates are higher in the UK than in the US, then the forward sterling pound would cost fewer dollars than will the spot sterling pound. The forward sterling pound will be at a discount and the forward dollar at a premium (Grabe (1996): 106). 24 See Appendix 4
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Tsiang (1959) emphasise that it has been argued that, given arbitrage funds do not run out, such arbitrage operations25 would tend to eliminate this inequality through some or all of the following possible effects: raising the spot rate of sterling in terms of dollars (SR), lowering the forward rate
d f (FR), raising the short term interest rate in the US (i t) and lowering the one in UK (i t). As a consequence, the equilibrium relationship between the spot and forward exchange rates in one side and the interest rates in the two financial centres on the other side is said to be;
f d FR/SR (1+ i t) = (1+ i t) (3) In other words, the process of covered interest arbitrage drives the international currency and money markets toward the equilibrium described by the covered interest rate parity. Thus, covered interest arbitrage should continue until interest rate parity is re-established, due to the fact that arbitragers are able to earn risk free profits by repeating the cycle as often as possible (David et al. (1998): 124).
2.2.2 Covered Interest Parity (CIP) Covered interest parity (CIP) was not recorded as a formal condition in the finance literature until the twentieth century, although foreign exchange traders were engaged in covered interest rate arbitrage as mentioned above (Peel and Taylor (2002): 52-53). Yet, Keynes (1923) gave the initial verbal formal definition of covered interest parity (CIP)26, “... forward quotations for the purchase of the currency of the dearer money market tend to be cheaper than spot quotations by a percentage per month equal to the excess of the interest which can be earned in a month in the dearer market over what can be earned in the cheaper” (Keynes (1923): 103-104). As presented above, Tsiang (1959) states the equilibrium relationship between the spot and forward exchange rates and the interest rates in two money markets as the following
f d (Ft / St)* (1+ i t) = (1+ i t) (3)
Tsiang (1959) further, states that given Ft / St expressed as 1 +p, where p (i.e., (Ft - St)/ St) is the forward premium (or forward discount, if negative) on sterling as defined above, then equation (3)
f d above becomes (1+p) (1+ i t) = (1+ i t) (4) If the term pib in (4) is considered as of second order of small magnitude and therefore neglected, this equation can be further simplified to p= id- if (4`) This corresponds to the usual verbal formulation of the so-called interest parity theory of forward exchange, which maintains that the forward premium (or discount) tends to be equal to the interest
25 I.e. for instance, transfers of spot funds from US to UK along with an equal amount of forward sales of sterling for dollars. 26 in an article first published in a British newspaper, The Manchester Guardian in 1922 and subsequently published in the revised form in his Tract on Monetary Reform (Peel and Taylor (2002): 53).
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differential between the two money markets concerned (Tsiang (1959): 80). Moosa (2003) highlights that this relationship is an application of the law of one price to financial markets i.e. identical financial assets should produce identical returns after covering the foreign exchange risk (Moosa (2003): 19-20). The above statement has been reformulated by David et al. (1998) as the following; “the difference in the national interest rate rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs” (David et al. (1998): 122). Figure 4.227 depicts the interest rate parity condition, in order to give a better understanding of the
condition. Assume that St represents the spot exchange rate i.e. the pounds sterling-dollar rate,
quoted in terms of dollars per unit of pounds sterling, Ft is the three-month forward pounds sterling-
d f dollar rate quoted as for the spot rate, i t is the short-term dollar interest rate per three months, and i
t is short-term pounds sterling interest rate per three months. Again, given an investor with $100 who invests in a dollar money market instrument e.g. three months, the investor would earn the
d d dollar rate of interest, where i is the dollar rate of interest. This would result in a gain of (1+ i t) at the end of the period and thus, the three month investment in the dollar money market would
d become $100 *(1+ i t). Hence, given that the same sum in dollars is converted into pounds sterling at the current spot rate and invested for three months in the pounds sterling money market instrument and then converted back into dollars at the current forward rate for pounds sterling for
f three months delivery it would become 100$ x Ft / St (1+ i t). A dollar based investor would evaluate the relative returns of starting in the top left corner of figure 4.1, and investing in the dollars compared to investing in the pounds sterling market i.e. going
d f around the box to the top right corner. The comparison of returns would be (1+ i t) = St*(1+ i t) *
(1/ Ft). The left hand side of the equation is the gross return that the investor would earn by investing in dollars. The right hand side is the gross return that the investor would earn by exchanging dollars for sterling at the spot rate, investing the pounds sterling proceeds in the sterling money market, and simultaneously selling the principal plus interest in pounds sterling forward for dollars the current 90-day forward rate. Ignoring transactions costs, if the returns in dollars are equal between the two alternative money markets investments, the spot and forward rates are considered to be at interest rate parity (IRP). The transaction is covered due to the fact that the exchange rate back to dollars is guaranteed at the end of the 90 day period (David et al. (1998): 123). Several authors such as Tsiang (1959), Spraos (1959), and (Frenkel & Levich (1975) have
27 See Appendix 4
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emphasized the shortcoming of the interest rate parity theorem, hence this will be further elaborated on in chapter 5.
2.2.3 Equilibrium between Interest Rates and Exchange Rates Figure 2.1 depicts the no arbitrage condition i.e. equation (3). The interest rate difference is measured on the vertical axis, which illustrates the percentage difference between foreign (pounds sterling denominated) and domestic (dollar-denominated) interest rates, and the horizontal axis depicts the forward premium or discount on the pounds sterling. The interest rate parity line illustrates the equilibrium state, hence transaction costs grounds the line to be a band rather than a thin line. In general, transaction costs arise from foreign exchange and investment brokerage costs on shorting and going long securities (David et al. (1998): 124).
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Figure 2.1. Interest Rate Parity & Equilibrium
% difference between if – id
4
2
0 X -4 U
- Y 6 Z - 8 -6 -4 -2 0 2 4 4,8 % premium on foreign 3 currency (£) Source: (David et al. (1998): 126). Note: The given, percentage difference between if-id and the percentage premium on foreign currency (£) are fictive numbers, in order to give a more clear understanding this chapter.
Point x corresponds to one possible equilibrium position, where a -4 % interest differential on sterling securities would be offset by a 4 % premium on the forward sterling. The point above the line i.e. the disequilibrium point U, would encourage the interest rate arbitrager. That is the situation presented in figure 2.128. Point U is located above the interest rate parity line due to the fact that the percentage differential in interest rate is -4 % (annual basis), while the premium29 on the forward sterling is 4.83% (annual basis). However, the situation illustrated by point U is unbalanced as all investors would have an incentive to execute the similar covered interest arbitrage. The net result of the disequilibrium is that fund flows will narrow the gap in interest rates and/or decrease the premium on the forward sterling. That is market pressures will result point U to shift toward the interest rate parity band. Thus, equilibrium could be obtained at point Y, or at any other position between X and Z, depending on whether forward marker premiums are more or less easily shifted than interest rate differentials (David et al (1998): 126-27).
David et al. (1998) stress that the arbitrages gain is nearly risk free, except for a bank failure. It is also emphasised that some authors suggested the existence of political risk as some governments
28 Subject to the assumption that the 1+id= 1.04 and 1+if = 1.02 for 90 days. 29 Using the forward premium calculation, the actual premium on the sterling can be calculated as the following; (S 1- S2)/ S2 *100*(360 days/90 days) =i$-i£ (David et al. (1998): 124).
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may apply capital controls that would prevent execution of forward contracts. Hence, this risk is fairly distant for covered interest arbitrage between major financial centres, as a great deal of the funds used for covered interest arbitrage is in Eurodollars, however, this could be a concern for countries with political and fiscal instabilities David et al. (1998): 126). (BIS (2008) also emphasise that in today`s G10 currency markets, political risk is insignificant. It is further underscored that for CIP to hold it depends on lack of credit default risk (BIS (2008): 5). i.e. to say, in the interest rate parity theorem, credit risk has not been considered, as in credit risk theory, currency risk has not been considered. Nevertheless, the importance of credit risk is of major consequence in the recent financial turmoil. Yet, chapter 5 will further goes in deep with these possible factors that would have an effect on the deviation of the CIP.
2.2.4 The FX Swap & Covered Interest Parity (CIP) The next important question rises as an attempt to understand the relation between the money market spill over and the FX swap markets, what is the relation between the FX swap and the CIP. Thus, the first part will describe what a FX swap is and thereby its relation to CIP. An FX swap is described as a contract in which one party borrows a currency from another party, and at the same time lends a second currency to another party. FX swaps are perceived as effectively collateralised transactions, BIS (2008) stress that the collateral does not cover the entire counterparty risk as if one party to the swap defaults during the life of the contract period, the counterparty needs to reconstruct the position at the current market price, which requires replacement costs (BIS (2008): 4). Duffie & Huang (1996) further support that FX swaps are exposed to greater counterparty risk than interest rate swaps for the reason that, dissimilar to interest rate swaps, FX swaps entail the exchange of notional amounts at the start of the contract. Moreover, the volatility of FX rates tend to be greater than that of interest rates, which means that this also contribute to promote the counterparty risk in FX swaps above that of interest rate swaps (Duffie & Huang (1996): 939). An financial institution which is in call for foreign currency funding have the option to either borrow directly in the uncollateralised spot market of the currency or borrow in another, in general the domestic, uncollateralised spot market of the currency and convert the proceeds into an obligation in the desired currency through an FX swap. BIS (2008) identify this second option of funding as the total funding cost, which is called FX swap implied rate. Given a financial institution raising dollars via an FX swap with euros, it exchanges euros for dollars at the FX spot rate while contracting to exchange in the reverse direction at maturity at the FX forward rate. The FX swap implied dollar rate, in gross terms, generated from the euro can be written as;
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f Ft,t+s / St= (1+i t,t+s)
Where St is the FX spot rate between the sterling and dollar at time t, Ft,t+s is the FX forward rate
f sterling contracted at time t for exchange at time t+s, and it,t+s = it,t+s is the uncollateralised euro cash
fixed interest rate from time t to time t+s. Ft,t+s / St corresponds to the sterling/dollar forward discount rate that is used for the FX swap price quotation30. The relative cost factor plays a significant role in the use of the FX swap to raise dollars i.e. whether an institution would be encouraged to borrow domestic currency funds in the uncollateralised spot market and use the FX swap to raise dollars, should depend on whether the FX swap implied dollar rate is lower than the rate of the uncollateralised dollar funds. In other words, the choice between investing in collateralised (FX swap) versus uncollateralised dollar funding, dependence on the perspective of covered interest parity as it implies a comparison of one uncollateralised rate e.g. dollar, versus an uncollateralised rate e.g. sterling combined with an FX swap (sterling for dollar). The equality of dollar rates and of FX swap implied dollar rates defines a the following condition;
d f 1+it,t+s = Ft,t+s / St (1+ rt,t+s ) (a)
d Where it,t+s is defined as the uncollateralised dollar cash fixed interest rate. Equation (a) corresponds to the covered interest parity condition as presented above in section 2.2.2. As mentioned above, CIP states that interest rate disparities between currencies should be perfectly reflected in the FX forward discount rates for the reason that, otherwise arbitrageurs could transact in interest and exchange markets to make a risk free profit. A fair amount of research has been devoted to the empirical validation of the condition and various empirically studies have shown that the parity condition is not always satisfied. The reasons for the deviation of the CIP will be further elaborated on the chapter 5.
30 More, correctly the price of FX swap is usually quoted as Ft,t+s - St. Referring back to the interest rate parity i.e. equation (3), the forward rate is d f given as a function of the spot rate; Ft,t+s = St ((1+i ) /(1+i ) ), therefore the spot rate should be the swap rate Ft,t+s - St ( Grabbe (1996): 109).
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CHAPTER 3: BRIEF SUMMARY OF EVENTS LEADING TO THE CRISIS IN THE INTERBANK AND FX SWAP MARKET Credit- liquidity crises are not a new phenomenon, the first credit crunch was observed in 1966, which was due to the municipal bond market (Wray (1999): 3). This period was followed by major disruptions in financial markets, the Asian currency crisis in 1997, and the Russian31 and the LTCM32 crises` in 1998. Although, the crises have occurred based on various reasons such as credit loss, increasing interest rates, what are characteristics for all of them is that liquidity issues have appeared in financial markets subsequentially (Plesner (2008): 4); (Danmarks Nationalbank (1999): 51-53). The main source of uncertainty surrounding the economic outlook of today has been due to the deterioration of the US housing market (BoE (2007): 17); (BoF (2008): 20); Plesner (2007): 2); Brunnermeier (2009): 82); Kempa (2008): 5); Danmarks Nationalbank (2008f): 37). Yet, in order to understand the financial crisis, which surfaced in the summer of 2007 and hit the core money markets, it is vital to recall some key factors leading up this turmoil.
Key Factors Leading up the Turmoil in the International Money Markets In the period of 2002-04, there had been recorded an unusual stability and historically low interest rates in the financial markets of developed countries33 (Kempa (2008): 3); (Brunnermeier (2009): 77). According to Kempa (2008) this has pursued investors, facing historically low interest rates, higher yields and turned to more risky assets and heavy leveraging. Increased market liquidity, hence, led to an unsafe reaction i.e. once a certain market section was targeted, increasing liquidity reduced the volatility and resulting yields which persuaded investors to move to even more risky assets (Kempa (2008): 3).
At the same time, the banking system underwent a vital transformation i.e. the traditional banking model, in which the issuing banks hold loans until they are repaid, was replaced by the “originate to distribute” banking model. The initiative behind the “originate and distribute” scheme34 was to securitize and sell the loans on the financial markets (ECB 2007): 12). In the traditional banking, the credit granting and credit risk relied in the bank, and therefore, a proper credit rating was conducted to eligible customers. Whereas the new scheme allowed the banks that originally granted
31 In August 1998, Russia suspended payments on its foreign debt and abandoned stabilisation of the rouble against the dollar (Danmarks Nationalbank (1999): 51). 32 See Appendix 5 33 See Appendix 5 34 See Appendix 5 for the major actors in the new model
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the loans to transfer part of the risk to counterparties and obtain the liquidity for new lending 35. This meant that as the banks had little incentive to take care of approving loan applications and monitoring loans as they only faced the “pipeline risk” of holding a loan for few months until the risks were passed on (Plesner (2007): 3); Kempa (2008): 3); (Brunnemeier (2009): 82); Danmarks Nationalbank (2008f): 12). Plesner (2007) stresses that the scheme also invites to moral hazard as the intermediary bank (or broker) focus on deal flow, and in seeking commission have led to warped creditworthiness evaluations. This has been the case, in particular with house buyers36, who in traditional banking would face difficulties obtaining a loan, have managed to obtain loans with the new scheme. These types of loans have been forwarded by the intermediary brokers to investment banks, and as a mean to offload risk, banks typically created structured products often referred to as collateralised debt obligations (CDOs), which offloaded the risk to institutional investors, hedge funds, and other participants on the global financial markets (Brunnemeier (2009): 78-79); Plesner (2007): 4)37.
Hence, the overloaded liquidity pumped into the markets during this time period started to back fire, in particular in mid-2004 where an increase in the Fed Funds Rate38 started. As an outcome this affected many sub-prime borrowers as they were unable to repay their loans. Although, the American Central Bank tried to intervene through the 2005 and the first half of 2006, the turmoil was already out of control (Plesner (2007): 3). Nevertheless, it is to be noticed that according to Plesner (2007) the complex instruments such as CDO`s are not the factor to hold responsible as it is solely a redistribution of the credit risk at better but rather the moral hazard issue in the model that is the main subject. Additionally, the fact that new participants engaged into investing in complex and illiquid products, in the credit market when lacking knowledge and experience with pricing and managing credit risk, deteriorate the circumstances further (Plesner (2007): 5). Furthermore, excess liquidity in the markets has been presented as a significant reason to the developed distress in the US housing market, and the lack of early intervention of central bank of US (Plesner (2007): 3).
35 This is obtained by separating assets from the balance sheet, and makes the investor directly dependent of the outcome of this. When the assets are sold forward to the SPV, and the banks do not have any juristic obligations towards the assets, the credit risk will be gradually decreased (Grosen (2008): 1-3); Plesner (2007): 4-5). 36 Also called subprime borrowers, as even NINJA (No Income, No Job, Assets), and Liar Loans have been issued loans (Plesner (2007): 4). 37 However, conventionally investment banks do not perform credit analysis, and for that reason they were left with the ratings of the bonds (CDO- tranches) credit quality, performed by the credit agencies. As the credit rating agencies were paid by the investment banks, subjective opinions about the creditworthiness of the issuer have been performed (Plesner (2007): 4); Brunnermeier (2009): 82). A remarkable issue related to ratings on complex instruments such as CDO`s, is that they are not comparable to conventionally bonds due to the high credit risk related to CDO´s (Plesner (2005-2): 14-15). 38 See Appendix 5, for the development of the Fed Funds Rate from 1991-2007.
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Overall, a combination of cheap credit and low lending standards resulted in the housing rage that laid initially basis for the credit crunch followed by the liquidity crisis (Plesner (2007): 3); Brunnemeier (2009): 78, 82); Berman (2007): C1); BoE (2007): 17). As pointed out by Ricardo J. Caballero and Arvind Krishnamurthy in the Bank of France Financial Stability Review (BoF (2008) and Plesner (2007), defaults on subprime mortgages were expected as the subprime market is the most risky segment of the mortgage market. It is hardly surprising that some borrowers would default on their loans. Yet, the occurrences of defaults have been the trigger for the current severe liquidity crisis that has rapt markets from consumer credit to corporate credit (BoF (2008): 10); Plesner (2007): 1). The acknowledged sub-prime related cost in the financial sector has been stated to be 120 billions dollars (Danmarks Nationalbank (2008-1): 2). BoF (2008) further highlights that the subprime losses were relative small, even the worst case estimates gave a loss at USD 250 billion, which is “a drop in the bucket relative to the trillions of dollars of financial instruments traded in the world’s marketplaces” (BoF (2008): 10).
US Sub-Prime Crisis Trigger Wider Market Turmoil & Hit Core Money Markets A fundamental question is how did the US sub-prime crisis to such an enormous extent that the core money markets have been hit? Figure 3.1 below describes the overall development quite well in a sub-sequential manner (BoE (2007): 40). Figure 3.2 The phases of the Crisis
Source: (BoE (2007): 40). As mentioned above, initially, it was observed a rise in the US sub-prime mortgage arrears. This resulted in many homeowners into force sales of their properties. Followed by this, the crisis
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spreads to other markets through the CDO`s and other complex products39. As the cost of insuring a basket of mortgages of certain ratings against default increased downgrading on related ABS and other structured instruments occurred. This resulted in a series of write-downs and loss of confidence in the value of ABS globally. As a part of the “originate and distribute” model, many banks created separate entities, SIVs, which were dependent on the originate banks but not included in their balance sheets40. SIVs were established to fund the CDOs through ABCPs. The major obstacle relied in the fact that ABCP`s are typically short term investments that mature between 3-6 months, were issued subsequently with the security of payments from CDO`s (ECB (2007): 32). This of course resulted in a duration gap. Thus, as the liquidity in the securitization market dried up, outstanding ABCP could not be rolled over, and SIVs had to sell assets in order to obtain liquidity, as many of the exposures were effectively financed on a rolling basis by short term funds (BIS (2009-101th): 17). The already ongoing sale of special liquid CDOs resulted in rapid decrease in market prices of high –quality tranches41. The degraded market liquidity resulted in liquidity injections from the liquidity facilities of the originated banks, which meant an increase of call risk as the risk flow returned to the balance sheets of the banks. Along with shortage of liquidity, major banks wrote-down mortgage related securities even further. Although the aggregate amount of write downs42 was higher in the united state, the amount of write downs of European banks is remarkable. The events in the US impacted financial intermediaries in Europe as credit risk from US ended up in the hands of global investors (ECB (2008-I): 10); ECB (2007): 31-32). As figure 3.2 depicts in July 2007 the market for short term ABCP started to dry up (Brunnermeier (2009): 84).
39 These products will not be elaborated on here, as it is out of the scope of the paper. 40 This was due to the Basel regulations, however this will not be further elaborated on as it is out the scope of this paper. 41 This triggered further market turmoil in”safe havens”, government bond markets (Plesner (2008): 7). 42 See Appendix 6, for the US European and Euro Area Banks` Write-Downs in the period from December 2007 to October 2008 & Write-Downs from Structured Finance Products, broken down by region and sector of May 2008.
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Figure 3.3 Outstanding ABCP43 and Unsecured CP
Source: (Brunnermeier (2009):84). All this resulted in dramatic liquidity degradation due to the sharp decline in the risk appetite of global investors and increase in market volatility, which hit core money market markets on 9 August 2007 (Plesner (2008): 7-8); Plesner (2007): 3, 5); (BoE (2007): 17-19, 40); (BoF (2008): 10); ECB (2007): 81); BIS-No.31 (2008): 1); BIS (2009-101th): 17). It is also to be stated that the CP issuing vehicles return to their sponsor banks and their liquidity provision commitments, prompted banks to retain contingent liquidity, which in turn brought the interbank market to a standstill. ECB (2007) further argues that the interbank market activity may have been affected further by uncertainty about the quality of the assets counterparties (ECB (2007): 30-31). Thus, the rest of the paper aims to give a more accurate picture of the development of the crisis in the money markets and the spill over to the FX Swap market.
43 See appendix 12, for the structure of ABCP Program.
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CHAPTER 4: DESCRIPTIVE STATISTICS This section aims to describe the financial situation in the international interbank markets and the FX swap markets by the use of available statistics. This chapter is divided into two main parts, the first part describes the international interbank market, and thereafter describe the tension developed in the international interbank markets through two measures that reflect the liquidity risk and the credit risk. The second part of the paper international FX swap markets followed by a description of the market via equivalent measures.
4.1 International Interbank Markets This sub-section, primarily aims to provide an overview of the fundamental characteristics of the International Interbank Markets. Initially, a brief historic introduction to the international interbank markets will be presented, which will be followed by a description of what he interbank market is, and how it is functioned is described. Thereafter, there will be a brief introduction of the role of money market rates.
4.1.1 Brief Historic Introduction of the International Interbank Market “Financial markets have existed for several years i.e. since mankind settled down to growing crops and trading tem with others. Financial markets are in different forms and operate in varied ways, which serve the same functions such as price settings, asset valuation, arbitrage, raising capital, commercial transactions, investing, and risk management” (Levinson (2005): 1-2).
Even though that there exists evidence that foreign currency deposits were held by banks before World War II, it is only since the late 1950s that the interbank markets have grown rapidly and consistently44 (Arvind (1994): 124). The growth in the international trade increased the demand for international currencies and the interbank market was created as a result of legal transactions of private investors looking for the best returns on their investments (Arvind (1994): 125, 127). Hence, the interbank market expanded significantly in recent years as a result of the general outflow of money from the banking industry45 (Levinson (2005): 37). Today, the interbank market is an
44 Dufey and Giddy identified three necessary conditions for the functioning of external markets, which were not, satisfied until the late 1950s and thereby the reason for why the interbank market did not start growing until the late 1950s . 1)Foreign-based entities must possess the freedom to maintain and transfer demand deposit balances i.e. no restrictions on nonresident inpayments, outpayments, and transfers, 2) Interbanks must be able to offer external deposits and loans at competitive rates in a convenient location, 3) Demand for external currency deposits and loans (Dufey and Giddy (1994): 10-11). 45 This process is referred to as disintermediation (Levinson (2005): 37).
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unsecured segment46 of the core money markets47, where banks conduct their transactions at great amounts. The international interbank markets do not exist in a particular place or operate in alliance to a single set of rules, neither do they offer a single set of posted prices, with a given current interest rate for money48 (BIS (1983): 7). Rather, they are webs of borrowers and lenders, all linked by telephones and PC`s, and at the centre of each web is the central bank whose policies determine the short-term interest rates for that currency. Market participants in the interbank markets are banks which are either lenders or borrowers (Aikman (2008): 8). Yet, the major criteria for participation are that the banks establishes itself as suitably creditworthy in the eyes of the other banks and that it is not constrained by regulatory obstacles49 (BIS (1983): 7); Levinson (2005): 38); Madura (2000): 137).
Known Aspect of Banking International Interbank transactions are a known aspect of banking. According to Franklin et al (2008), in modern financial systems, interbank markets play at least two vital roles. Primarily, it is in such markets that central banks actively intervene to guide their policy interest rates, hence this will be further elaborated on in chapter 6 (Franklin et al (2008): 1). Nevertheless, central banks plays a crucial role in the interbank markets, as they operate as granting short term collateralised loans50 to banks, which deposit the loan proceeds at the central bank. It is the task of the banks to redistribute the liquidity through the money market to balance liquidity supply and demand on an ongoing basis. It can be stated that the central bank liquidity is the current account51 of the banks deposited at the central bank. Thus, as the recent turmoil resulted in a reluctance of redistribution of liquidity by banks, the function52 of central bank became much more significant in order for maintaining the function of the international interbank markets as the banks require central bank liquidity for their interbank
46 See Appendix 6, for the most well known secured and unsecured segment developments in the money markets. 47 Money market instruments are issued when ever experienced a temporary shortage of cash, and due to the fact that money markets serve businesses, the average transaction size is very large (Madura (2000): 137). There are several types of money market instruments which are issued in the primary market (The primary market is referred to the initial offering of a security i.e. whether a stock, a bond, a loan, or a derivative instrument. While the secondary market refers to the market where existing securities can be traded between investors (Arvind (1994): 166)) by corporations and governments to obtain short term funds through sale in the secondary market (Madura (2000): 125), (Levinson (2005): 42). 48 Rather, they are webs of borrowers and lenders, all linked by telephones and PC`s, and at the centre of each web is the central bank whose policies determine the short-term interest rates for that currency (BIS (1983): 7). 49 Such as exchange controls or supervisory limits (BIS (1983): 7). 50 This collateral, usually consists of securities of high credit quality i.e. for instance government bonds. When a loan is transacted, it is credited to the account of the bank at the central bank, which in return receives collateral for the loan. On expiry, the principal and interest are debited to the account of the bank, and the collateral is returned. Given a bank is unable to repay the loan, the central bank would keep the collateral, which the central bank protect themselves against losses on loans (Danmarks NationalBank (2008-1.Q); 38). 51 I.e. the amount that the banks can use for their payments (Danmarks NationalBank (2008-1.Q); 37). 52 In general, central bankss provide liquidity mainly by the means of open market operations. Central banks conduct new open market operations regularly, order to always enable adequate liquidity in the banking system (Danmarks NationalBank (2008-1.Q); 38).
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payments. This, exchange of liquidity is illustrated by the figure below. Given a Bank B, which liquidity requirement exceeds its borrowing from the central banks. In a steady period, Bank B would cover its borrowing in the money market from Bank A, which is assumed to have a liquidity surplus. Figure 4.4 Illustration of Liquidity Swap
Normal Turmoil
Collateral Deposit Bank Bank A A
Loan Loan Centr Centr Loan al Loan al Bank Bank Bank Collateral Bank Collateral Source: DanmarksB Nationalbank (2008-1.Q): 39). B
Hence, in a situation of turmoil, obstacles may occur in the market e.g. if Bank A constructs its own contingency liquidity, preferring deposits at the central bank where the funds can be made available at short notice. Bank A places more liquidity than normal at the central bank, while the central bank lends a larger amount to Bank B against collateral, whereby the short term money market is partly replaced by balances at the central bank. Subject to the recent tensions in the money markets, various numbers of central banks have had to adjust their liquidity management (Danmarks Nationalbank (2008-1.Q): 39); Wu (2008): 1); Borio and Nelson (2008): 31-32).
Secondly, well functioning interbank markets effectively channel liquidity from institutions with a surplus of funds to those in need, allowing for more efficient financial intermediation (BIS (2001): 1); Franklin et al (2008): 1). Hefferman (2005) call attentions on that international interbank market have become a global liquidity distributor as well, i.e. excess liquidity regions is able to pass on liquidity to regions with a liquidity deficit, which is subject to the globalisation. In addition, interbank markets also became global capital distributors; deposits placed at banks are on lent to other banks (Hefferman (2005): 66).
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4.1.1.1 Role of Money Market53 Benchmarks54 Interest rates at which banks extend short term loans to one another have assumed international significance. Therefore, well established benchmarks are vital to the efficient functioning of the instruments in the market. Hence, the importance of benchmarks for short term interest rates goes beyond their use in contracts. They attach the short end of the yield curve, and thereby conveying information regarding expected future policy rates and other macroeconomic fundamentals. Money market rates are also used as a reference to terms of many financial derivatives55.
A main requirement of a benchmark has been characterized as being liquid. Movements in benchmark yields should not be driven by order imbalances but rather only reflect new information concerning fundamentals (Wooldridge (2001): 55). Gyntelberg and Wooldridge (2008) further stress that benchmark yields do not necessarily need to be risk free rates. Indeed, interest rates will small credit risk premium may be more effective as they reflect the rates faced by financial institutions. Yet, it is stated that the risk premium in the benchmark56 yields is required to be predictable if the yields are to be a stable reference for pricing (Gyntelberg and Wooldridge (2008): 60). Today, many financial instruments have interest rates linked to Libor i.e. the interest rate at which
57 banks in London offer to lend funds to each other just prior to 11:00 local time (BBA (2009): 7). According to Baba (2009) Libor capture the rates paid on unsecured interbank deposits at large globally active banks. Currently, Libor is fixed for 15 different maturities from overnight to 12 months, in ten currencies58. A more recent interest rate, Euribor, which is the rate at which European banks lend to each other. In the US the Fed funds rate, the rate at which banks with excess reserves lend to those that are temporarily short of reserves. Since, it is the main policy lever of the Federal Reserve Board, it is a vital economic indicator. Each of these rates is applied solely to
53 Gyntelberg and Wooldridge (2008) highlight that the use of money market rates to price other financial instruments can be traced back to 1970s. The unpredictability in inflation at the time led long term fixed rate securities unattractive to investors. Thus, in response floating rate bonds were introduced with coupon payments connected to money market rates plus a credit spread. This pricing mechanism has also been observed in the syndicated loan market, which initiated to grow around the same time period (Gadanecz (2004): 76-77). 54 Money market rates are referenced in several financial contracts (Gyntelberg and Wooldridge (2008): 59). 55 For instance, future contracts followed by forward rate agreements and interest rate swaps were among the first to emerge. This was followed by swaptions, cross currency swaps as well to be priced of money market rates (Stigum and Crescenzi (2007): 893-894); Gyntelberg and Wooldridge (2008): 60). 56 It is notable that the benchmark status is gained through competition. Thus, it may result in a change to an alternative reference rate. E.g. in the US money market in mid 1980s, US Treasury bills were the pre-eminet short term reference rate, by the late 1980s, three month Libor was the well established Benchmark rate in the US dollar money market (2001): 39-41). 57 “An individual BBA Libor Contributor Panel Bank will contribute the rate at which it could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 11:00” (BBA (2009): 7). 58 These include the Australian dollar, the Canadian dollar, the Danish krone, the euro, the Japanese yen, the New Zealand dollar, the pound sterling, the Swedish krona, the Swiss franc and the US dollar. Note that similar fixing arrangement appear in the all these markets, hence this will not be further explained.
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loans to healthy, creditworthy institutions. Thus, a bank that believes another bank to face credit default will charge higher interest rate or may even refuse to lend at all (Gyntelberg and Wooldridge (2008): 61); Levinson (2005): 49).
4.1.2 Liquidity Measures: Libor-OIS Spreads This sub-section aims to describe the development of the turmoil in the international interbank markets through liquidity measures like Libor-OIS spreads, collateralised and uncollateralised spreads, and the term lending spreads. On Thursday, 9 August 2007 traders in New York, London, and other financial centers around the world unexpectedly experienced a rapid change in conditions in the overall money markets. What began as deterioration in the US subprime mortgage sector rapidly to other markets59, as also mentioned in chapter 3 (IMF (2008c): 86-87); Heider et al. (2009): 1); Baba (2009d): 24). This development was surprising for many banks, in particular after many years of comparative calm (Taylor and Williams (2008a): 1). The stress in the interbank lending market became evident from the behaviour of the Libor60, which is illustrated by the figure 4.2 below, where the spread of three- month US dollar Libor over OIS during 2007-2009 is depicted. As it can be observed, this market tension was observed in the majority of the international interbank lending markets i.e. US, euro area, UK, Switzerland, and the Japanese market as well. 9 August the initial increase in the spread has been observed all over, though differences exists in the increase in the basis points from market to market.
4.1.2.1 The US Interbank Market The first quarter of 2007, the US Libor-OIS spread was recorded to be 8 basis points, whereas on 9 August 2007 the three month US Libor-OIS spread increased to 40 basis points (Michaud and Upper (2008): 49); Cecchetti (2008): 9); Baba (2009d): 35). At the fourth quarter of 2008, the spread increased to 123 basis points, whereas in March 2009 it became 99 basis points a decrease of 24 basis points (IMF 2009): 41).
59 See Appendix 6, for the developments of the other severely affect core money markets. 60 The benchmark rate on interbank lending set by a eight large UK banks each morning. The Libor lending is uncollateralized like the federal funds market (BBA (2009): 7).
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4.1.2.2 The Euro-Area Interbank Market Until 9 August 2007, the unsecured euro interbank market were characterized by very low spread around five basis points, and insignificant amount of liquidity deposit at the ECB (Heider et al. (2009): 2); Danmarks NationalBank (2008-1Q): 38-39). Yet, the fortune of the European interbank market was not much different from the US interbank market. Time zone frictions resulted in large swings over the day in the demand for US dollar interbank funds. As European banks have few local sources of dollar funding, they preferred to secure funds from the interbank market early in the US trading session. Hence, US banks with excess reserves choose to defer lending until later in the trading day, when their net funding position became more definite. The disparity intensified the upward pressure on the US dollar overnight interbank rate in Europe (CGSF (2008-No.31): 4). Hence, as the figure also shows, the time period after the default of Lehman brothers, was characterised by crucial higher compared to the period prior to the default. As of 28 September 2008, the spread increased even further to a maximum of 186 basis points (BIS (2009-79th): 15); Heider et al. (2009): 2); Michaud and Upper (2008): 49); ECB (2009-MB June): 31). However, this pattern also account for the other markets, but with degrees of spreads, as mentioned above. In March 2009, the euro Libor-OIS spread became 82 basis points (IMF 2009): 41).
4.1.2.3 The UK Interbank Market Figure 4.2 shows that the pound sterling Libor-OIS spread before 9 August 2007 has been quite narrowed. In the first quarter of 2007 the spread has been 6 basis points, whereas in the fourth quarter of 2008 it increased to 165 basis points, whereas in March 2009, it decreased 120 basis points, a decrease of 45 basis points (IMF 2009): 41). The euro area and the UK area have developed less alike the US, where as the spread compared to the Switzerland and Japan has been at lower levels.
4.1.2.4 The Japanese Interbank Market As the figure 4.2 illustrates the Japanese spread has been a bit higher prior to 9 August compared to the other economies. The first quarter of 2007, the Japanese spread has been recorded to be 16 basis points, whereas the highest spread has been in the fourth quarter of 2008, i.e. 73 basis points, which indicates that the default of Lehman Brothers has also affected the Japanese interbank market. The spread recorded in March 2009 shows a decrease of 24 basis points i.e. a spread of 49 basis points (IMF 2009): 41). Japanese interest rates have been much lower than interest rates in the US, Europe
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and UK. This indicates different risk factors in the banking sectors (Taylor and Williams (2008a): 1).
Figure 4.5 Three-Month Libor-OIS Spreads of Euro, Pound Sterling, Swiss Franc, and Yen, March. 2007 -March 2009
Euro Pound Sterling
Yen
According to Hui (2009) a bank verifies which other banks it is willing to involve itself with in transactions involving credit risk i.e. which banks is willing to place deposits with and which it is willing to buy and sell foreign exchange with. Given the assessment of the creditworthiness of the Source:other banks, (Hui (2009): the bank 22). decides the greatest size of exposure it is willing to have. It is further stated that this can operate as a liquidity constraint on covered arbitrage operations (Hui (2009): 4). Adrian and Shin (2008) argue that the liquidity constraint can be linked to the balance sheet of the financial intermediaries. It is stated that aggregate liquidity can be understood as the rate of growth of the aggregate financial sector balance sheet. I.e. when asset price increase, balance sheets of financial intermediaries, usually become stronger and (without adjustment of asset holding) their leverage tends to be too low. Then, financial intermediaries hold surplus capital, for such surplus capacity to be used an expansion of the balance sheet is required. That is, on the liability side, more short term debt would increase, and on the asset side, there would be a search for potential borrowers. So, aggregate liquidity is well connected to how hard the financial intermediaries search
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for borrowers. On the other hand, when asset prices decrease during financial turmoil, the balance sheet contracts and therefore become reluctant to lend. Such behavior reduces the size of exposure to other financial intermediaries. Such manner reduces their size of exposure to other banks, then the aggregated liquidity declines (Adrian and Shin (2008): 4). This is the scenario that occurred in the turmoil from 2007-2009, where asset prices declined, and the balance sheets of banks contracted, which made banks reluctant to lend in the interbank market as well as in the rest of the money markets. As a consequence, this reduced the funding liquidity, and required higher risk premiums i.e. greater aggregate price of risk, for lending with longer maturity. Furthermore, this reluctance to lend to each other in the interbank market at longer maturity contributed to the considerable rise in spreads between Libor and the overnight index swap (OIS) rates in the US and euro area, UK and Japan in August 2007. And as it can be seen the spreads persisted at high levels during the financial crisis until 2009.
Under normal conditions, the OIS rates tend to move very closely to the corresponding currency Libor, and thus the spread between Libor and OIS is less than ten basis points. But what does the Libor/ OIS spread tells us? This is probably best explained by Alan Greenspan (2009), former Federal Reserve Chairman who states that “Libor-OIS remains a barometer of fears of bank insolvency.” As the Libor is the rate at which banks indicate they are willing to lend to other banks for a specified term of the loan, the OIS61 rates is expected future overnight rates for the following two reasons; 1)the counterparty risk related with the OIS contracts is relatively small due to no principle is exchanged. In addition, the residual risk is alleviated by collateral and netting agreements. 2) the liquidity risk premia involved in OIS rates is assumed to be very low due to lack of any initial cash flow (Michaud and Upper (2008): 49). In the literature, the Libor-OIS spread is a standard measure indicator of funding risk in the term interbank market (Allen and Carletti (2008): 4); Heider (2009): 2); Schwarz (2009): 5); IMF (2008c): 110); IMF (2009-Update): 1); Eisenschmidt and Tapking (2009): 7); Hui (2009): 7).
61 In such a contract, two parties agree that one will pay the other a rate of interest that is the difference between the term OIS rate and the geometric average the overnight federal funds rate (each country has a similar rate) over the term of the contract. The term OIS rate is a measure of the expectations of the market due to no exchange of principle, i.e. funds are exchanged only at the maturity of the contract, when the party pays the net interest obligation to the other (Thornton (2009): 1).
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4.1.3 Secured and Unsecured Spreads However, Taylor and Williams (2008ab) stress that another very good measure of interbank risk is the Libor-Repo (government) spread as it is the difference in rates between secured and unsecured lending between banks at the same maturity (Taylor and Williams (2008b): 6); Taylor and Williams (2008a): 12); Taylor (2009): 10). Hence, due to the unavailability to Bloomberg, there have been no possibility to extract the needed data, and this thesis has been restricted available publications with the newest possible data. Therefore, this section will also describe the Libor-Repo spreads, in order to draw a more coherent conclusion. Interbank markets, were weathering a time period, where considerable uncertainty about the quality of bank loans and their other assets resulted in uncertainty regarding creditworthiness of counterparties. Concerns related to credit conditions resulted to deep and persistent liquidity crisis. As a result, the spread between unsecured and secured short term interbank financing rates widened radically, as shown in the figure 4.3 below. The spread widened from a few basis points to 50-100 basis points in August 2007. In particular the widening for US dollar and pounds sterling were highest compared to euro, which experienced a spread of a bit more than 50 basis points.
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Figure 4.6 Spreads between Secured and Unsecured Three-Month Deposit Rates
Source: (Danmarks Nationalbank (2009-Q1): 47). Note: The rate of interest on a 3-month interest-rate swap has been applied as the collateralised rate. The most recent observations are from 3 March 2009. Please, ignore the red line. However, the greatest spread has been observed in the fourth quarter of 2008, which is equivalent with the bankruptcy of the Lehman Brothers. Especially, the spread in the US dollars increased rapidly, to approximately 360 basis points, whereas the spread between secured and unsecured three month deposit rates for pound sterling and Euro was lower compared to the US dollars, around 250 basis points and around 200 basis points, respectively. Albeit, with the entrance of year 2009, the spreads have terminated down to spreads around 100 basis points for Euro and US dollar, whereas the spread for pounds sterling has been higher compared to the other two currencies.
Examining further the differences in maturities, the below figure 4.4 depicts the development of the spread between the Euribor62 (unsecured rate) and the Eurepo63 (secured rate) for the three-month, six-month and one-year maturities. Within few days after the turmoil onset, the spreads increased from around 10 basis points (bps) to around 70 (bps), and remained at these levels until later summer 2008. In September 2008, after the default of Lehman Brothers, spreads increased even further to reach levels above 200 pbs.
62 Euribor has been established by the European Banking Federation to benchmark in zone rates, which applies a concept of country quota. Each in- country has at least one bank represented on the Panel and smaller countries will rotate membership of the Panel amongst their leading commercial banks every 6 months. Today, Euribor has a panel of 49 reference banks from in zone countries as well as international banks. Bank of Tokyo- Mitsubishi, Chase, Citibank, JP Morgan Bank of America and UBS represents the international banks. The averaging method of BBA Libor and Euribor is quite similar, although solely the top and bottom 15 per cent are rejected in the process. Thus, the difference in topping and tailing will result in being a greater ratio of smaller banks to larger banks in Euribor (www.bbalibor.com/bba: 2009). 63 The Eurepo represents the an average general collateral (GC) repo rate from euro repo transactions (www.eurepo.org)
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Figure 4.7 Spreads between Secured and Unsecured Three-Month Deposit Rates
Source: Eisenschmidt and Tapking (2009): 29). Note: The darkest lines, is the one-year maturity, the light line is the six-month maturity, whereas the dotted line is three months. It is to be mentioned that the dis-clarity relies in the source the chart Eisenschmidthas been originated. and Tapking (2009) highlight another vital observation i.e. to end of quarter effects in the market during the turmoil. For instance, the one-month Euribor (unsecured) spreads has been higher in the last month of each quarter, in particular in the last month of 2007, in contract to other months since the onset of the turmoil. Correspondingly, the one-week Euribor spread has also been higher in the last week of each quarter than in other weeks.
ECB (2008-June) emphasise that close to the year or quarter ends, or the end any other important financial reporting period, institutions often attempt to improve their apparent financial health preparation for public disclosure of their accounts, also known as window dressing. This is executed, in order to improve appearance to shareholders, analysts or, in the case of financial firms, even to ensure that regulatory requirements. In particular, financial firms may reduce their credit exposure and increase their liquidity position. Furthermore, it is stated that concerns related to window dressing can lead to increased liquidity risk as many banks reduce their lending when engaged in these above mentioned activities, which is reflected in the increase in overnight rates as the year-end or quarter-end come near (ECB (2008-June): 78).
A very important observation is the great spread between the one year and three-month rates, which indicates that banks seem to raise funds repeatedly at shorter maturities in the unsecured market compared to longer maturities, and in this case at one year and six month maturities. The spread in
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the fourth quarter of 2008 is in particular very high. Spreads between one year maturities reached around below 250 bps., six months around 200 bps., while three-month was around 170 bps.
Analysing the maturity situation further, according to ECB (2009mm) the unsecured market remained mainly on overnight market. In the second quarter of 2008 overnight activities represented around 70 per cent of the total lending and borrowing activity in the European unsecured market. ECB (2009-EMMS) states that 96 per cent of unsecured transactions appeared at maturities of less than one month in 2008. In general, the credit risk associated with unsecured operations leads banks to limit their unsecured transactions in longer maturities. On the borrowing side, the exposure in the overnight segment declined from 11 per cent to 8 per cent of total exposure while the proportion in maturities above one-month increased. While, the lending side, there was a significant decrease in exposure with maturities longer than three months, in particular for one year maturity, which decreased from 20 per cent to 9 percent of total exposure (ECB (2009mm): 14). Eisenschmidt and Tapking (2009) argue that banks can only attain funds from borrowing at the Euribor but lending at funds at Euribor is hardly possible as prime banks prefer to borrow repeatedly overnight at the low unsecured overnight rates rather than for a longer period at the higher Euribor (Eisenschmidt and Tapking (2009): 16). This reflects that in a period of elevated liquidity risk or funding risk, banks choose to lend liquidity short term in the unsecured market rather than long term due to the uncertainties of funding defaults.
4.1.4 Credit Measures: CDS Spreads This second part of the first main parts aims to describe the credit default swap spreads for the major economies. It is to be noticed that the five year bank credit default spreads for selected Japanese banks were not possible to be obtained, and therefore it is omitted in this subsection.
4.1.4.1 Five- Year Bank CDS Spreads for Selected Banks Before, examining the development in the CDS spreads for selected banks, there will be a brief description of a CDS, which intends to give a better understanding of why it is applied as a credit measure in the literature.
Credit default swaps64 are insurance against credit risk, it is a contract that guarantee to cover losses on certain securities in the event of a default. A CDS is a bilateral agreement between two parties, a
64 Lately, many institutions have engaged in trading with credit risk, and one of the most widely used are credit default swaps, CDS, a type of insurance contracts. The notional amount of outstanding CDS has increased from $34,4 trillion in December 2006 to $62 trillion at year end 2007, and thereby decreased to $38,6 trillion at year end 2008 (www.isda.org (2009): 22 August 2009).
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buyer and a seller of credit protection. The seller compensates the buyer if the issuer fails to service the debt holding (such as bonds, notes, loans and commercial papers), which has been issued by a third party, called the reference entity. One of the parties agreement purchases, for an agreed period, protection against a credit event i.e. the case when the reference entity default or failure to meet its payment obligations. Given that the reference entity defaults or fails to meet its payment obligation the contract must be settled i.e. the buyer receives the difference between the value of the asset and its nominal value. Most of the CDS has a maturity of five years (Bomfim (2005): 69); Danmarks Nationalbank (2008-Q3): 103-104). The insurance premium of a CDS is called the credit default swap premium or the CDS spread. The spread is quoted in basis points per annum of the contracts notational value and is generally paid quarterly (Adelson (2004): 3). In the literature, a range of authors have agree on to identify the attribution of counterparty risk, credit default swaps spreads are used to measure the default risk of the banks i.e. the probability that banks may default on their debt (Hui (2009): 11); BIS (2009abc): 48); IMF (2009-Update): 1); Taylor and Williams (2008a): 6, 18); Eisenschmidt and Tapking (2009): 29). Therefore, in this thesis this measure will also be used as an indicator of the default risk that has appeared in the markets.
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Figure 4.8 Five-Year Bank CDS Spreads for Selected Banks, 2007-2009.
Source: (IMF (2009-update):1). Note: in basis points Figure 4.5 above illustrates two major rapid rising in the five- year CDS for several major financial institutions in US, Euro area and the UK. The initial increase can be observed already in July of 2007, but the spread was less than 100 basis points. Hence, the first major increases occurred in the first quarter of 2008 for all the economies, but the US spread was higher (around 290) compared to the Euro area and UK, which were less than 200 basis points. Looking at the market developments, 20 March, 2008 Bearn Stearns faced liquidity shortage, and bailout of Bear Stearns and JPMorgan Chase, seems to play a role behind the high CDS spread in US (BIS (2009abc): 4, 17, 110). Examining the second and the greatest spread that approximated 600 basis points, no doubt the Lehman brothers default played a role in the spread, whereas in the Euro area and UK the spread increased a bit more than 200 but less than 300 basis points.
4.2 International FX Swap Markets As mentioned earlier in the chapter, this section intends to describe the international FX swap market. Therefore, the first part of this chapter aims to give a brief introduction to the international FX swap market, and thereafter describe the tension developed in the market via liquidity measures. Every country prices are expressed in units of currency, either issued by the central banks of the countries or a different one in which individuals prefer to denominate their transactions. In order to judge the value of the currency itself, external reference is required i.e. the exchange rate. Determining the relative values of different currencies is the task of the foreign-exchange markets65 (Levinson (2005): 14). According to BIS (2007) the average daily turnover in traditional foreign
65 Since, ancient times, foreign-exchange has existed, and has flourished or diminished depending on the extent of international trade and the monetary arrangements of the day (Einzig (1962): 11-20). In particular, along with market forces determining exchanges (note: after late 1960s, the agreement of the Bretton Woods system i.e. exchange rates based on fixed rates, started to break down and in 1972 the governments of the largest economies decided to let market forces determine exchange rates, which resulted uncertainty about the level of exchange rates, see Monetary Control Act of 1980 in the U.S. (Levinson (2005): 14,18)), have led to dramatic growth in currency trading.
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exchange markets to be $3.2 trillion in 2007, which is growth of 69 per cent since April 2004, and therefore is also one of the most liquid markets (BIS (2007n): 1).
The foreign exchange markets consist of four different markets66 which function separately, yet are very closely connected. Yet, most foreign exchange trading67 occurs in the derivatives market. In principle, the term describes a large number of financial instruments, as well as options and futures, while in general practice, it refers to instruments such as forwards contracts, FX-swaps, FRAs, and barrier options (Levinson (2005): 14-17). More than half of the increase in turnover accounts for by the growth in FX swaps, which increased 80 percent compared with 45 per cent over the previous three year BIS (2007n): 1). Several factors have been presented in the literature for the ongoing growth in this segment. The fact that FX markets offer investors with short term horizons, quite attractive risk adjusted returns on the year, given the fact that financial markets volatility was at historically low levels has been one of the reasons. Additionally, longer term investors such as pension funds have also contributed to the increase in turnover by diversifying portfolios internationally (BIS (2007n): 5); Galati and Heath (2007): 65).
Subsequent to the core money markets were hit by the turmoil in the second half of 2007, there has been observed a spill over to FX swap and cross-currency swap markets as well (Baba et al. (2008): 73); BoE (2007): 18); Baba & Packer (2009): 1). When dealing with foreign currencies, a bank is exposed to the risk that a unexpected change in foreign exchange rates or market liquidity, or both, could stridently widen the liquidity mismatch being run (Basel Komiteen (2000): 20). Thus, given the fact that FX and related derivatives market are some of the most liquid markets (Baba et al (2008): 73), and given the fact that from mid-August to mid-September, trading liquidity in the FX swap market was severely impaired, it is crucial to investigate the effect of the turmoil in these markets and possible factors behind it (Federal Reserve Bank of New York (2007): 10).
4.2.1 Liquidity Risk Measure- FX Swap Spread In the academic literature, it is stated that the FX swap spread that represents the premium or discount is reflected in the Swap implied USD funding rate i.e. the deviation from CIP, which is calculated from the Libor-OIS spreads for the foreign currency and USD respectively (Hui (2009):
66 These are the following; the spot market, the future market, option market, and the derivative markets (Levinson (2005): 15). 67 In most conditions, foreign exchange trading is very much connected with the trading of securities, in particular bonds and money market instruments. An investor who believes that a particular currency will appreciate will not want to hold that currency in cash form, as it will earn no return. As an alternative, the investor will buy the preferred currency, invest it in highly liquid interest-bearing assets, and then sell those assets to obtain cash at the time the investor wishes to sell the currency itself (Levinson (2005): 14-17).
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8); Baba et al (2008): 78); Baba and Packer (2009a): 8). It is further highlighted that the FX swap spread is a measure of the funding liquidity risk (Baba et al (2008): 73); Hui (2009): 8). Moreover, it is necessary to state that to identify the attribution of counterparty risk to the deviations from CIP, credit default swap (CDS) spreads are applied to measure the default risk of the banks in the US, the euro area, the UK (Hui (2009): 11); Baba and Packer (2009a): 8). Hence, as this has already been described in section 4.1.4.1, see kindly section 4.1.4.1. Therefore the following will only describe the development in the FX swap spread for the following currencies, USD dollars, Euro, pound sterling, yen during the turmoil period. From the start of the turmoil in August 2007, there emerged a spread between the short term FX swap implied dollar rate, across a number of funding currencies, and the corresponding dollar Libor rate, as illustrated in figure 4.6. This remarkable pricing behaviour revealed vital and constant departure from CIP. In normal time period, the FX swap spread is efficiently arbitraged and close to zero for most currency pair i.e. CIP holds (Hui (2009): 3); Baba and Packer (2009): 4); Baba et al. (2008): 79). According to Babe et al (2008) the FX swap-implied dollar rates from the euro and sterling moved jointly quite closely with dollar Libor. Looking for yen, the spread was negative in the first quarter of 2007, for the three month maturities (note: as can be seen from the figure, this is also the case for six month maturity, and then a slight positive reaction occurred but never ranged beyond 5-10 basis points. Thus, suggest that CIP broadly was not deviated for these currency pairs in the period previous the turmoil (Babe et al (2008): 77).
Figure 4.6 illustrates how much the three- month, six-month and 12- month US funding rate implied from the FX swaps in EUR, GBP and JPY deviates from the corresponding Libor i.e. the risk premium demanded by dollar lenders in the swap market, or in other words the departure from CIP during 9 August 2007 to 31 March 2009.
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Figure 4.9 Spread between FX swap-implied rates and Libor EUR GBP
JPY
Source: Hui (2009): 21).
After 9 August for three currencies an upward trend was observed, the spreads between the FX swap-implied dollar rates and dollar Libor also increased, moving from July levels, i.e. close to 35 basis points in the euro, 25 basis points in sterling, and 15 basis points in the yen.
Anecdotal evidence suggest European financial institutions that needed US dollars, hence faced keen concerns over their own credit risk in dollar cash markets, turned to the FX swap market to raise dollars using both the euro and sterling as funding currencies (Baba et al (2008): 78); Baba & packer (2009b): 1). It is further stated that movements in the FX swap price deviated from CIP conditions may have reflected a shift towards one sided order flow in the FX swap market with
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liquidity further deteriorated subject to the fact that institutions intensified inquest for counterparty risk were concentrated on the dollar borrowing side of the market as well.
Hence, another explanation has been that the reported Libor has been fewer representatives of actual interbank rates during distress instant, and the gap may have been greater for dollar Libor than Libor for other currencies. Regardless, the FX swap implied dollar rates appeared more sensitive to the increased demand for dollar funding than reported dollar Libor rates68. Nevertheless, the level of divergence from CIP has been recorded to be smaller than in the case of the euro and sterling, even the FX swap implied dollar rates from the yen showed a degree of deviations, signifying that FX swaps in yen has also been used in heightened volumes to secure dollar funding. (Baba et al (2008): 78).
The greatest increase in the FX swap spread increased in the fourth quarter of 2008, which is similar to trend observed in the other figures seen in the previous sub-sections. Another analogous character observed is that this spread has been highest for three month maturities, and then six- months compared to the one year maturities. This also reflect that market participant have seeked for short FX swapping rather than longer maturities. In early September and onwards to the year- end, there have been anecdotal reports of selected European financial institutions with access to the yen FX swap market swapping great amounts of yen into dollars to meet their dollar funding needs, which explains the maturity preferences observed in the figure above.
Furthermore, market participants have also implied that Japanese banks, expected an increased demand of European financial institutions in the yen/dollar FX swap market, showed efforts to secure the necessary dollar funding via FX swap ahead of the fiscal half year end (September) and calendar year end (BIS (2007n): 14, 16-17); Baba et al (2008): 79); European Central Bank (2007): 40). Beginning in November and December, the spread between the FX swap implied dollar rate from yen and dollar Libor became quite minor compared to other FX swap market, indicating that the confidence in the yen swap market to fund demand for dollar liquidity had greatly declined by then. This decline has partly been due to the rigorous measures by central banking society to ease liquidity concerns in the markets (Borio & Nelson (2008): 39); Baba et al (2008): 79). Yet, as of
68 It is to be remarked that, observing intraday movement of FX swap implied dollar rates would have presented a deeper insight into the US dollar funding needs, hence intraday cash rates consistent with the intraday FX forward discount rates have not been available (Baba et al (2008): 79).
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end-Jan, there were expectations of renewal demand in swap market for dollar liquidity later in 2008, especially through the euro/dollar and yen/dollar pairs (BIS (2007n): 15).
Nevertheless, just like in the previous figures with the New Year, 2009 the spreads has decreased to almost levels seen in the beginning of 2007, which reflects a degree of recovery in the market. The possible explanations behind this reaction will be discussion in chapter 5.
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CHAPTER 5: EMPIRICAL ANALYSIS & DISCUSSION The last main part of the thesis has described the development financial turmoil in the international interbank and the FX swap markets from 2007 to 2009. The objective of this chapter is to analyse and discuss the empirical frameworks in the light of the applied theories and the presented statistics in the previous chapters. Identifying the underlying factors is quite important, in analysing the development of the main central banks interventions in these markets, and its effectiveness. Therefore, this chapter is to be perceived as a link to the following chapter, where the central banks actions and effectiveness are analysed.
5.1 International Interbank Markets The aim of this section is initially to analyse the factors that triggered the tensions observed in the international interbank market as seen in chapter 4 i.e. the Libor-OIS spreads and CDS spreads. Thereafter there will be a discussion of the underlying factors behind the widened spreads observed in the interbank markets.
5.1.1 Factors triggered the Tension in Interbank Markets One of the main responsibilities of interbank markets is to reallocate liquidity among banks that are subject to particular distress. If banks hoard liquidity and as a result they are able to cover the particular distress from their own liquidity holding, then their unwillingness to lend to other banks is not an issue. Hence, if, the liquidity hoarding prevents the reshuffling of liquidity to deficient, but solvent banks, then the poorly functioning interbank market would be a issue warranting central banks provision (Allen and Carletti (2008):2); Bhattacharya and Gale (1987): 6); Bhattacharya and Fulghieri (1994): 288-289, 291-292). As illustrated in chapter 4 (CDS spreads), credit and liquidity (Libo-OIS spread) risk increased as market participants became worried about their counterparties availability and funding possibilities, and as a result banks became reluctant to lend to each other. Hieder et al (2009) stress the significance of lack of supply in the market breakdown, and therefore liquidity hoarding is examined here as the market has the banks engaged in such an activity (Hieder et al (2009): 23). Liquidity Hoarding As illustrated in figure 4.2, the spread between the three-month Libor and the OIS increased, but this increase had an effect on the amount of liquidity parked by banks at the ECB. The time period from 9 August 2007 to 28 September, there was not observed large amounts of funds parking at the ECB, except the 2007 year-end effects. However, as of 28 September 2008, along with very high
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increased spreads i.e. 186 basis points see figure 5.1, a dramatic increase in the amounts of banks brought to the ECB.
The ECB, Fed and BoE impose an average reserve requirement on banks i.e. banks must maintain a certain average minimum deposit at the central bank for a reserve maintenance period of around one month in the ECB and BoE69, and of two weeks in the Fed70. The purpose is to stabilise the overnight interest rate. This gives the banks an incentive to lend liquidity in the money markets when the overnight interest rate is high in contrast to the interest rate on deposits in reserve requirement accounts. Alternatively, the banks have an incentive to maintain ample reserves in periods when the overnight interest rates are low. (Danmarks NationalBank (2008-1Q): 39-40); Cecchetti (2008): 7-8). Thus, banks prefer to lend out excess cash since the rate offered by the overnight deposit facility of ECB is penalising relative to rates available in interbank markets (Heider et al. (2009): 2); Danmarks NationalBank (2008-1Q): 38-39).
Heider et al (2009) stress that the amounts increase more than 1800 fold between the week of 1 September 2008 and the week of 29 September 2008. As the figure also depicts, the amounts deposited with the ECB rose from a daily average of €0.09 billion in the week beginning 1 September 2008 to €169,41 billion in the week of 29 September 2008 (Heider et al (2009): 2).
69 Concerning the BoE, the banks have the possibility to themselves to determine, within certain limits, the size of their reserve requirements and change them from month to month (Danmarks NationalBank (2008-1Q): 39-40). 70 The requirement is calculated as a percentage of the two-week average of balances on deposits with unlimited withdrawal privileges. The requirement is adjusted, with the first few million dollars in deposits exempt, then three percent on the next $45 million or so, and 10 per cent on amounts above that. It is to be remarked that balances are not remunerated i.e. interest rate is zero, therefore expensive to hold, so banks economise on the need to hold them. Banks choose to apply complex algorithms to shift funds in and out of accounts with limited withdrawal benefits that do not attract a reserve requirements, which makes the reserve requirement irrelevant (Cecchetti (2008): 8).
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Figure 5.1 Interbank Spread, Recourse to the ECB Deposit Facility, and Liquidity Absorbing Fine Tuning Operations, Aug.2008-Nov.2008
The amounts deposited with the ECB were triggered by the collapse of Washington Mutual, ten days after the Lehman failure, 15 September 2008. This also shows a sharper market reassessment of risk in the summer of 2007, after subprime mortgage backed securities were discovered in portfolio were discovered in portfolios of banks, which led to a further increase in the level and
Source: (Heider et al (2009): 24). 71 dispersionNote: the Fine ofTuning counterparty Operations will risk be followingfurther elaborated the eventson, in chapter in September X 2008 (Heider et al (2009): 3).
The last weekend of September 2008, banks started to hoard their own liquidity and parked it at the ECB rather than lending it out i.e. banks started to store more funds than actually necessary to satisfy the reserve requirement, also meaning that banks became reluctant to lend to each other i.e. the credit risk increased as they became worried about whether the counterparty were able to repay the loan (Kempa (2008): 7); (IMF (2009): 41); (World Bank (2008): 66); (Frexias(2009): 5); (BIS (2009-79th) 27); (Danmarks Nationalbank (2008-1Q): 49); (Michaud and Upper (2008): 47); (CGFS (2008): 4). This behaviour reduced the efficiency of the interbank market in the distribution to banks that needed funding.
This situation paved the way to the announcement of the ECB, on 8 October 2008 stating a change in its tender procedure and standing facility corridor. The Fed also conducted a similar action, which is explained in further details in chapter 6. In 9 October 2008, the deposit facility rate was increased from 100 to 50 basis points below the policy rate, therefore making deposits relatively more attractive. The marginal lending facility rate was reduced from 100 to 50 basis points above the policy rate i.e. 4.75 per cent (ECB (2008-PR 8 Oct): 1). In addition, from the operation settled on 15 October 2008, through the weekly main refinancing operation carried out via a fixed rate
71 Major dramatic events was surrounding the last weekend of September 2008. For instance, before the weekend of 27-28 September, Washington Mutual, the largest S&L firm in the US was seized by the FDIC and sold to JP Morgan Chase (FDIC (2008): 1). Over the weekend, it was announced that British mortgage lender Bradford & Bingley had to be rescued (Reuter (2008): 1). Furthermore, Benelux announced the injection of € 11.2 billion into Fortis Bank (Government of Netherlands (2008): 1). And on the following Monday, Germany reported the rescue of Hypo Real Estate and Iceland nationalised Glitnir (Financial Market Stabilization Fund (SoFFin) (2009): 1); Heider (2009: 23).
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tender procedure with full part at the policy rate, ECB was satisfying demand for liquidity (ECB (2008-PR15 Oct). Meantime, as the figure 5.2 below also illustrate, banks began to bring funds to the ECB, the average daily volume in the overnight unsecured interbank market (Eonia) halved and the net amount of central bank liquidity outstanding decreased rapidly. At the start of the crisis in August 2007, the Eonia increased in volume. The year prior to 9 August 2007, the average daily volume was recorded to € 40.91 billion, which increased by 27 per cent to an average of €52.12 billion between 9 August 2007 and 26 September 2008 (Heider et al (2009): 24).
Figure 5.2 Net Stock of Central bank Liquidity Outstanding (left scale) and overnight unsecured market volume (right scale), Aug.2008-Nov. 2008
The net amount of central bank liquidity outstanding shown in the figure above, is the total stock of liquidity provided minus the amount absorbed in all open market operations and recourses to its standing facilities. Source: (Heider (2009): 25).
Moreover, a similar trend the figures illustrate is that, although the ECB provided large amounts of liquidity during September 2008, banks were not depositing funding until the end of the month. Heider et al (2009) emphasise that, there is evidence that the number of banks participating in the liquidity absorbing operations of the ECB is the not the same as the range of banks participating in its liquidity providing operations. Therefore, as of the last weekend of September 2008, banks were hoarding their own liquidity and depositing it at the ECB rather than lending it out. In addition, Hieder et al (2009) stress those safer banks left the unsecured market as they have alternative to obtain liquidity than riskier banks. It is further stated that this is in according with anecdotal
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evidence about the reluctance of banks to borrow at high rates, in order to avoid signaling that they are poor banks.
In the literature, there is a great discussion of the underlying reasons for the tension in the international interbank market. It is very significant to diagnose the underlying reason for the increased spreads as observed in the market, Chapter 4, in order to determine type of necessary policy response (Taylor (2009) : 10), which is discussed in chapter 6. Therefore, this section aims to examine the underlying reason behind the spreads observed in the international interbank market in the theoretical frame i.e. the role of credit and liquidity risk.
5.1.2 Credit and Liquidity Risk Generally, “there should be an arbitrage that allows a bank to borrow overnight, lend for three months, and hedge the risk that the overnight rate will move in the federal funds futures market leaving only a small residual level of credit and liquidity risk that accounts for the small spread observed before the beginning of the crisis. A relevant question is why banks were unable to do so” (Cecchetti (2008): 9).
In the literature, there seems to be a degree of uncertainty of the underlying dynamics behind the observed spreads in the international interbank markets. Empirical work on decomposing risk spreads has generally found greater role for credit risk (Beber et al (2006): 3); Longstaff, Mithal and Neis (2005a): 18); McAndrews, Sarkar and Wang (2008): 4). (Flannery (1996) focuses on credit risk under asymmetric information, illustrating how adverse selection may lead to break down of the interbank market (Flannery (1996): 811-12). (Taylor and Williams (2008a) is also one of those authors who provide evidence that credit risk is predominant in the turmoil in the international interbank markets with more newer data (Taylor and Williams (2008a): 33), whereas Taylor and Williams (2008b) stress that counterparty risk is a main explanation behind the spreads on term lending rates (Taylor and Williams (2008b): 20).
This has been supported by a more recent study, where Taylor (2009) stress that he interviewed traders who deal in the interbank market, and many trader and monetary officials expressed their thoughts as the main problem relied in liquidity matters. Hence, the empirical work suggests that the spread between the unsecured and secured interbank rates and Libor-OIS spreads cannot be explained merely by liquidity problem of the kind that could be alleviated merely by central bank
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liquidity tools. Rather, it has been suggested that it has been an inherently a counterparty risk matter, which is connected to the underlying cause of the financial crisis, as explain in chapter 3 i.e. a fundamental problem in the financial sector relating to risk. Taylor (2009) further states that the turmoil is not like the Great Depression where printing money or providing liquidity is the solution (Taylor (2009): 10).
However, there is also a range of evidence academic literature that apply the Diamond and Dybvig (1983) approach, which generally focus on liquidity risk as an factor for breakdown of interbank market. The role of liquidity has also been documented by studies focusing on intraday patterns of traded volumes and interest rates in the interbank market (Baglioni and Monticini (2008ab): 8-9, 9). Although, there is an uncertain about the explanation behind the tension experienced in the international interbank market. Still, there is an upcoming evidence documenting the both risks i.e. liquidity and credit risk in the recent turmoil. Duffie et al (2003), Longstaff et al (2005) argue that both credit and liquidity concerns are critical components of explaining the spreads (Beber et al (2006): 3); Longstaff et al (2005a): 2246-7).
More recent studies, like Baglioni (2009) also argue that both elements play a relevant role, and support the view that the interplay between the two sources of risk should be examined. Baglioni (2009) further stress that if liquidity were the only explanation for the turmoil, central banks should have been able to quickly restore normal conditions in the interbank markets, by injections of great amounts of liquidity and making the supply of bank reserves meet the level demanded by the banking system, or neither solve issues related to the creditworthiness of counterparties. Hence, as so far this has not been a solution. Moreover, if credit risk were the only explanation, it would be difficult to explain the noteworthy differences across market segments, especially why the short term segment has been rather resistant from the crunch, and why banks should lend short term at normal rates, if it its believed that counterparty may not be able to repay (Baglioni (2009): 2, 6, 19)
Borio (2008) also emphasise the role of both credit and liquidity risk in the recent turmoil in the interbank market. It is stated that as banks began to hoard liquidity and became reluctant to lend to each other, as mentioned earlier, the risk premium reflect a combination of liquidity and counterparty credit risks, in an extent which is hard to separate in the explanation of the tension Borio (2008): 7). Brunnermeier (2009) argue that an increase in the mortgage delinquencies due to a
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nationwide decline in housing prices, and the counterparty risk involved in this phase of the overall financial crisis, triggered the liquidity crisis that emerged in summer 2007 (Brunnermeier (2009): 98). Another author who support this view is Schwarz (2009), who find that both credit and liquidity factors are important in explaining the widening of Libor-OIS spreads, but he also stress that market liquidity explains a greater share of the widening (Schwarz (2009): 3). Furthermore, Eisenschmidt and Tapking (2009) also argue that there is evidence that the tensions in the interbank market cannot alone be explained by high credit risk but, funding liquidity risk of lenders in the unsecured term markets also plays a central role (Eisenschmidt and Tapking (2009): 16-18).
ECB (2009-EMMS) also argue that the unsecured markets suffered dearly in activity, which not only general market liquidity risk but also credit and funding risk concerns play a vital role in explain the declines in the unsecured markets. It is stated that many banks reduced and in some incidences withdrew credit lines they had with counterparties for unsecured transactions due to rising credit risk concerns, which was illustrated in figure 4.3, in chapter 4. Furthermore, as mentioned in chapter 5 the funding risk that certain institutions faced was due to that they had no access to liquidity in the market, which led them to hoard additional liquidity on their balance sheets. As also mentioned in chapter 4, the funding sources switched from very short term borrowing, where the main majority of overall unsecured activity usually takes place, to secured longer term instruments, which suffered from a less severe liquidity strain than the unsecured interbank deposit segment. There was a general decline in unsecured transaction volumes, hence an increase of 31 percent in borrowing transactions for maturities longer than one month, ECB (2009mm) argue that this possible indicate the increased need for some banks to obtain long-term funding (ECB (2009mm): 13-14). Moreover, it is stressed that these above matters converted to increasing funding costs, which contributed to augment reputational concerns. Thus, some banks including those with greater incentive not to disclose their cost of funding, seek for alternative funding sources. In some cases, these banks remedied intragroup funding, whereby some specialised institutions reduced lending to external counterparties in a number of market segments in order to become liquidity providers to the group treasury function (ECB (2009mm): 12-13).
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5.2 International FX Swap Markets This chapter aims to investigate the spill over effect of the financial crisis in the FX swap market and thereby analyse the underlying dynamics behind the turmoil experienced in the international FX swap markets. Thus, the first part of this section aims to analyse the underlying dynamics behind the turmoil spill over from the interbank market to the FX swap market. The second part will examine the underlying factors of the FX swaps spread i.e. the deviation from CIP observed in chapter 4.
5.2.1 Turmoil Spill over of from the International Interbank Market to FX Swap Markets Melvin and Taylor (2009) characterize the entrance of the crisis in the FX as “relatively late”. In the early summer of 2007, it was apparent that several markets along the money markets were hit by the crisis. As FX market participants were watching other markets with growing nervousness, wondering when, if and how the market turmoil would extend to exchange rates, their fears became true on 16 August 2007 as the crisis spilled over to the most liquid financial markets, FX markets 72, including the FX swap markets (Melvin and Taylor (2009): 2); Baba et al. (2008): 73); BoE (2007): 18); Baba & Packer (2009): 1). Therefore, a critical element in better understanding how the crisis has spilled over to the FX swap market, it is essential to identify the origins behind this.
Thus, this section will start will an initial description of dynamics of how the international interbank lending market affected the FX swap markets. Thereafter, the underlying dynamics behind the deviations of the FX swap spreads observed in chapter 4 i.e. deviation of CIP, will be presented, in order to assess the implemented central bank policies adopted during the crisis, which is elaborated in chapter 6.
5.2.2 Dynamics behind the Spill over to FX swap market As mentioned in chapter 4, in early August 2007, the overnight interbank in the US and Europe came under upward pressure. Time zone frictions led to large swings over the day in the demand for US interbank funds (BIS-No.31 (2008): 4). Baba, Packer and Nagano (2008) stress that a vital aspect of the turbulence was due to shortage of dollar funding for many institutions (Baba, Packer and Nagano (2008): 73). The origins of the US dollar shortage, mentioned above, derivated from an
72 On this day, major unwinding of the carry trade (i.e. a popular strategy for currency investors, where a long position is taken in high interest rate currencies funded by selling low interest rates currencies e.g. in the summer of 2007, many currency investors were short Japanese yen and long Australian and New Zealand dollars. According to IRP the interest differential between two currencies should be offset by a change in the exchange rates. However, in such an event, a carry trader investor would argue that this exchange rate offset will not occur so the interest differential is earned and many currency market investors suffered great losses. Therefore, the date of the beginning of the crisis in the FX market is August 2007 (Melvin and Taylor (2009): 2-3).
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intense growth in the US dollar assets of European banks over the past decade that sharply outpaced the growth in their retail deposits (McGuire and von Peter, (2008):33-34 ; (2009): 54). Yet, at the same time, the usual suppliers of dollar funds to the interbank market were in an attempt to conserve their liquidity, due to their own growing needs and increased concerns over counterparty credit risk (Baba (2009d): 24). Already, in the summer of 2007, European financial institutions tried to secure dollar funds to support troubled US conduits for which they had committed backup liquidity facilities (McGuire and von Peter, (2008): 36). Hence, even more severe market strains were following the failure of Lehman Brothers. At the end of September 2008, the interbank markets were shut down, and banks sought dollar financing elsewhere (Gadanecz, Gyntelberg adnd McGuire (2009): 19). Subject to this critical demand/supply conditions in the interbank market, many non-US financial institutions endeavoured to convert euro into dollar liquidity through FX swaps, one of the most liquid financial markets, after the turmoil started in early August 2007 (ECB (2007): 31); Baba et al (2008): 73); Baba and Packer (2008): 4); BIS (2008abc): 25). In the third quarter of 2008, the interbank lending continued to contract, also indicating the ongoing tensions in interbank credit markets. As illustrated in the figure 5.3 below, on residency basis, total claims on banks73 grew by $150 billion, after the extraordinary decline of more than $800 billion in the second quarter of 2008.
Figure 5.3 Changes in Gross International Claims, in billions of US dollars
Looking at the claims on currency basis, it can be seen that in the second quarter of 2008, the decline in US dollar has been much higher than the other currency, which is also in consistent with the above stated regarding demand/supply conditions in the interbank markets. Gadanecz, Source:Gyntelberg (Gadanecz, adnd GyntelbergMcGuire adnd(2009) McGuire stress (2009): that the30) lending to other (unaffiliated) banks decreased in the third quarter as well by $ 173 billion.
73 Including inter office claims.
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Figure 5.4 shows a reduction of the interbank lending, in particular by French, Belgian and German banks accounted for much of the decline. French Banks reported a decline to around $250 billion, whereas German banks a bit less than $250 billion. These two banks were also those with the highest consolidated foreign claims compared to the Belgian banks, which only reported around $600 billion in the beginning of 2008, but suffered a decline in the foreign claims of around $100 billion. Furthermore, only a slight decline for the interbank lending for Swiss banks have been observed compared to the other European banks. According to Gadanecz, Gyntelberg and McGuire (2009), in the third quarter of 2008, the outstanding stock of foreign claims in other banks declined by $744 billion (nine per cent)74.
Figure 5.4 Consolidated Foreign Claims, Amounts Outstanding, in billions of US dollars
In order to amidst these funding pressures, banks received liquidity support from central banks. Hence, this is further elaborated on in chapter 6. Overall, European financial institutions that needed
Source:US dollars, (Gadanecz, but Gyntelberg faced adnddelicate McGuire concerns (2009): 31). over their own counterparty/credit risk in dollar cash markets turned to the short term FX swap market to raise dollars using both the euro and sterling as funding currencies, and thereafter to long term FX swap markets, as they realised the turmoil would last longer than expected, see chapter 4 figure 4.6 (Baba and Packer (2008): 3); Baba (2009d): 24).
5.2.3 Dynamics behind the Deviations of the CIP in International FX Swap Market According to Taylor (1989) deviations of CIP occasionally occur during periods of turbulence (Taylor (1989): 389). As illustrated with the data above, since August 2007, the spread between the FX swap implied dollar rate and dollar Libor rate widened significantly, reaching higher than 40
74 Hence, the reduction of $146 billion recorded for Dutch banks, partly reflected the sale of business units by ABN AMRO. Furthermore, more generally, the depreciation of the euro against the US dollar reported in the third quarter accounted for an estimated 70 per cent of the overall reduction (Gadanecz, Gyntelberg adnd McGuire (2009): 20).
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basis points in September 2007, which indicates a large deviation from short term covered interest parity (CIP) (Baba (2009d): 24); (Hui et al (2009): 3). Although, the spread narrowed largely immediately after 2008 began, it resurged from early March. Baba (2009d) and Baba and Packer (2008a) stress that for CIP to hold strictly depends on negligible credit risk, liquidity risk, measurements errors, transaction costs and political risk (Baba (2009d): 26); (Baba and Packer (2008a): 5); (Akram et al (2006): 5). In the literature, a fair amount of research has been devoted to the empirical validation of the condition and various empirically studies have shown that the parity condition is not always satisfied (Officer and Willet (1979): 248). Yet, it is to be noticed that, there has only been conducted a limited amount of empirical research on the deviation during the recent turmoil, and therefore, the emphasis in searching for the correct dynamics behind the deviation in the recent turmoil will be the main purpose of this paper. Yet, the other possible explanation will also be included. The dynamics will be subsequently analysed in more depth.
5.2.3.1 Credit Risk and Liquidity Risk Albeit, as reflected in the theoretical framework in chapter 2, credit risk is not incorporated in covered interest parity theorem, in the literature, there is a disparity in how great role credit risk had on the FX swap spread i.e. deviation of CIP. Adler and Dumas (1976) were the first authors who introduced the credit risk in the foreign exchange market. Their model suggested that the presence of default risk on currency contracts may lead to deviations between the forward rate and the theoretical parity rate (Adler and Dumas (1976): 332). Stoll (1972) is one of the first authors who presented the credit risk as the major explanation factor behind the deviation of CIP (Stoll (1972): 115); (Hilley et al (1979); 99).
Numerous authors have agreed on the default risk as one major explanation factor behind the deviation of CIP in this recent financial turmoil. Recent study conducted by newer data subject to the financial crisis in the FX swap market indicates by Baba and Packer (2009a) suggest that deviations from the CIP condition in terms of the US dollar interest rate against the euro during the crisis period from August 2007 to mid –September 2008 are significantly associated with differences in the default risk between European and US financial institutions (Baba and Packer (2009a): 12).
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Another study conducted by Baba and Packer (2009b), again related to the recent turmoil in the FX swap market, find that the deviation from CIP in the Euro FX swap market has been due to reassessment of counterparty risk based on the data from August 2007 to September 2008 (Baba and Packer (2009b): 18). Hence, it is to be remarked that due to unavailable data after September 2008 is lacking in this study. The time period after mid-September is quite significant, as the market experienced more volatility with the default of the Lehman Brothers, as also illustrated by the figure 4.1 and 4.6. Hui (2009) find that, at the early stage of the crisis i.e. prior to the Lehman default, for euro, pound, Swiss franc and yen, the funding liquidity was the major concern and main determinant of the changes in the CIP (measured by the Libor/OIS spread). It is argued that this is also consistent with the market observation that many non-US financial institutions turned heavily on the FX swap markets to raise dollars for their funding needs when lending in the interbank market became impaired. However, examining the time period after the default of the Lehman Brothers another pattern shows up as explanation for the spread in the FX swap implied US dollar rates i.e. CIP deviation. Hui (2009) shows that the funding liquidity risk still remained a vital factor behind the FX swap spread, despite a fall occurred in the explanatory power for the euro, pound, Swiss franc and yen. In addition, counterparty risk became a significant explanation factor as well, after the Lehman default in the European economies in the CIP deviations for euro, pound and Swiss franc, which increased the premiums on the swap implied USD interest rate. Hui (2009) explains that the reduction in the explanatory power is partly attributed to the increasing idiosyncratic shocks as a consequence of the turmoil in the markets and the exceptional policy measures introduced by the central banks (Hui (2009): 9). Hui (2009) further examines the condition in the Asian currencies, and his empirical work he finds that, funding liquidity risk was lower in Hong Kong Dollar, yen and Singapore Dollar compared with that in the US counterparty risk was not perceived as a concern in the money and FX swap markets of these economies (Hui et al (2009): 2).
5.2.3.2 Transaction Costs A number of studies have analysed the deviation from the CIP in terms of transactions costs. Branson (1969) analysed the persisting deviations from the CIP in terms of transactions costs. It is stressed the existence of some minimum amount before movements of arbitrage funds to excites. I.e. broker`s fee, which reduces the net yield of the transaction. Branson (1969) estimates the minimum differential for both U.S.-U.K. arbitrage and U.S.-Canadian arbitrage to be 0.18 per cent
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per annum. This implies that an arbitrage transaction must give at least 0.18 percent before arbitragers, mainly New York banks are willing to move funds between the dollar and the pound sterling or between the dollar and the Canadian dollar (Branson (1969): 1034). It is to be noticed that Keynes (1924) suggested it to be 0.50 percent, and Einzig (1961) suggested 0.06 percent (Keynes (1924): 139); Einzig (1961): 50).
Other studies such as Frenkel and Levich (1975) measure deviations from CIP for the U.S.-U.K. exchange rate, where they estimate the transactions costs for arbitrage to be 0.145%--0.15% per annum, which is slightly lower than the estimate by Branson (1969) and Einzig (1961) (Frenkel and Levich (1975): 326, 331). Balke and Wohar (1998) investigates U.S.-U.K. data from 1974 until September 1993, and find that the average departures from the parity conditions was 0.08 per cent, again close to the previous studies except for Keynes (1924) (Balke and Wohar (1998): 546). Hence, according to Atkins (1991) and Clinton (1988), the empirical studies have demonstrated that transactions costs are much smaller than previously assumed (Atkins (1991): 325). Clinton (1988) estimates that in the Euromarket transaction costs between Canada and the US is low as 0.06 per cent on an annual basis (Clinton (1988): 365). Hence, Atkins (1991) argues that one would expect the Euromarket to have lower transactions costs as the same banks could provide deposits in both currencies, and therefore, it is assessed that a re-evaluation of the size is necessary. Studies conducted by Frenkel and Levich (1981) estimate a deviation from CIP over the period 1973-79 to be 0.21 per cent, whereas Longworth (1983) estimates it to be 0.24 per cent using US Eurodollar rates and Canadian chartered bank deposit rates. Whereas Juhl et al (2004) find significant evidence that due to slower information and communication technology during 1960s-and even 1980s, led higher transactions costs (Juhl et al (2004): 350-51); (Taylor (1987): 430-31).
Hence, as mentioned in chapter 2, the theoretical framework of CIP assumes that assets denominated in domestic and foreign currencies are freely traded internationally, and have negligible transaction costs and similar risks. In particular, transaction costs and political risk Alibar (1973) are largely negligible in the today`s G10 currency markets (Baba and Packer (2009a): 5); Taylor (1989): 386): Hui (2009): 6). Hence, according to Taylor (1989), during the floating of the sterling in 1972 and the inception of the European Monetary System in 1979, significant departures occurred from CIP for periods long enough to question the theory (Taylor (1989): 379-380, 384- 85). Moreover, so far no recent studies have been conducted with the recent turmoil. Therefore, in
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order to make a persistent conclusion whether transaction costs play an important role in the deviation from the recent turmoil in the FX swap market, more studies needs to be conducted.
5.2.3.3 Data imperfections: Beside the above mentioned studies, other authors have criticised the previous conducted empirical work for using time averaged data as opposed to point in time data. Taylor (1987, 1989) employs ‘high quality, high frequency’ and contemporaneously sampled data for spot and forward US--UK and UK-- German and euro-deposit interest rates. Taylor (1987, 1989) finds that very few profitable arbitrage opportunities during periods of turbulence, whereas during relatively calm, control period, he finds no evidence at all of unexploited profit opportunities (Taylor (1987): 435); (1989): 389). Agmon and Bronfeld (1975) do also suggest that the reported deviation from covered interest parity is almost certainly due to the data imperfections rather than any other reason (Agmon and Bronfeld (1975): 270, 277). Baba et al. (2008) also highlights that measurement error could have been explanation behind the spread between the FX swap implied dollar rate and dollar Libor. It is stated that during the recent turmoil, dollar Libor may have underestimated the dollar funding costs that European institutions actually faced (Baba et al. (2008): 77). Gyntelberg and Wooldridge (2008) stress that the institutions contributing to the Libor survey, may lead, in certain circumstances, to biased quotes on the part of institutions that wary of revealing information that might increase their borrowing costs in times of stress. It is stated that this factor alone could have created a spread between the FX swap implied dollar rate and dollar Libor (Gyntelberg and Wooldridge (2008): 65). However, this field needs further empirical studies, in order to determine the effect of it in the recent turmoil.
5.2.3.4 Recovery Time Balke and Wohar (1998) stress the significance of deviations from CIP is the speed with which short-run deviation from CIP are eliminated and convergence to equilibrium is achieved. It is further argued that, most of the empirical studies examine the validity of CIP, primarily with the size of deviations relative to estimates of transactions costs and pay less attention to the speed with which these profitable trading opportunities are eliminated (Balke and Wohar (1998): 536). Many studies have shown that, relevant markets are highly efficient in eliminating unexploited profit opportunities (Frenkel & Levich (1975): 326), (John et al. (1979): 103). Clinton (1998) assess through informal analysis that, at least for the Euro-market, profitable trading opportunities are small and transitory (Clinton (1998): 358-59). A similar result has been presented by Atkins (1991,
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1993) suggests that deviations from CIP in the Euro-market are in general eliminated within two days with this time decreasing as one moves from the 1970s through the 1980s (Atkins (1991): 187; (1993): 331). In contrast, Pippenger (1978) presents results that it can take up to several weeks for Canada and the U.S (Pippenger (1978): 189-91). Baba and Packer (2009a) highlights that most studies show that deviations from the short term CIP condition has decreased significantly, at least among G10 currencies (Baba and Packer (2009a: 5). Whereas, Akram et al (2006) provides evidence that short lived arbitrage opportunities arise in the major FX markets (Akram et al (2006): 24). Baba (2009) also emphasise that under the turmoil there has been existence of short term deviation of CIP in the FX swap market (Baba (2009). As shown in section X, the FX swap spread has remained widened for some time, at least longer than few weeks.
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CHAPTER 6: ANALYSIS AND DISCUSSION OF THE CENTRAL BANKS INTERVENTIONS “Neither the recent massive money injections, the coordinated lowering of interest rates nor the use of public funds to recapitalize banks have done much to restart interbank lending. This action did not solve the underlying problem preventing interbank lending: extreme information asymmetry” (Financial Times (2008-9 Nov.). The above quotation depicts the severity of the turmoil as a range of measures have not solved the existing problems in the interbank markets. This section aims to explore the major various measurements taken into account by the greatest central banks, and analyse the effect of the employed measurements in weathering the recent financial crisis.
6.1 Overall Central Bank Measures BIS (2008-No.31) stress that central banks responded to the strain in the international interbank markets by adjusting their operations in a range of manners75 to ease the liquidity demand of the banks (Danmarks NationalBank (2008-1.Q); 38). The sustained period of uncertainty in money market conditions led a range of central banks to response to with an array of measures, in order to calm short term interest rate volatility and, to address various types of funding market pressures (BIS-No.31 (2008): 1). In particular, there is no widely accepted theoretical analysis of how they operate. This lack of a theoretical framework meant that when banks stopped trading with each other soon after the crisis that initiated in August 2007, central banks were unsure accurately how to react (Franklin et al (2008): 1); (Frexias et al. (2009): 4). Therefore, the objective of this section is to outline a framework assessing the actions by the central banks. These days, central banks generally conduct money policy through targets on very short term interest rate. The approach comprises two key elements i.e. signaling the desired policy stance through the announcement of a key interest rate (the policy rate) and liquidity management operations, which cover various aspects of the operating framework76, which supports the desired stance by keeping the relevant market rate consistent with the policy rate. In general, liquidity management operations are designed and implemented cautiously to ensure that they influence only the specific market rate targeted by policy. Thus, they play a supportive role, neither impinging upon nor containing any information related to the stance of policy. Liquidity management operations can also be used purposely to influence specific elements of the monetary transmission
75 See Appendix 8, for the chronology of selected CB interventions. 76 These include the maturity, pricing and collateral requirements for central bank liquidity (BIS (2009abc): 94).
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mechanism, e.g. Certain asset prices, yields and funding conditions over and above the impact of the policy rate. The latter element is quite vital as funding conditions were worsening in the market. In this situation, the liquidity operations would play a more active role and become an essential part of the overall monetary policy stance. Operations in this range usually result in substantial changes in the balance sheet of the central banks, in terms of size, composition and risk profile. BIS (2009abc) referred to this time of activities to balance sheet policy. Each operation that has an impact on the balance sheet, the effect will be demonstrated on the balance sheet of the central banks. The various forms of balance sheet policy77 can be distinguished by the specific market that is targeted. Yet, the balance sheet policy employed in this recent crisis has targeted term money market rates and risk spreads. This is definite as illustrated in chapter 4 with high term rates, and credit and liquidity spreads. BIS (2009abc) argue that in principle, the effects of balance sheet policy may be conveyed through two focal channels. The first is the signaling effect i.e. operations performed by central banks or communication, influence public expectations about chief factors that support the market valuation of the assets, which is assessed quite powerful. These factors comprise expectations regarding the future course of policy, inflation, relative shortage of different assets or their risk and liquidity profiles78. The second channel works through the impact of central bank operations on the composition of private sector portfolios. Given assets that are imperfect substitutes for one another, changes in relative asset supplies through central bank operations greatly change the composition of portfolios. In order to compensate, relative asset yields usually need to change, and such changes may consecutively influence the real economy. To the degree that this process leads to stronger balance sheets, heightened collateral values and higher net worth, it may assist to release credit constraints, lower external finance premia, and hence refresh private sector intermediation79. Therefore, this section aims to outline the framework for reviewing the various aspects of the responses of the central banks. Therefore, the following section intends to give an overview of the central bank responses to strains in interbank markets. As solving the strains in the interbank market would consequently have an impact on the FX swap market strains.
77 FX intervention is the most regular form. In here, purchases or sales of foreign currency intend to impact the level of the exchange rate separately from the policy rate that defines the official policy stance (BIS (2009abc): 95). 78 For instance, the announcement of engagement in operations involved illiquid assets may in itself improve investor confidence in those assets, in that way reduce liquidity premia and stimulating trading activity. 79 An example of this is when risky private securities are purchased from banks in exchange for risk-free claims on the public sector, the resulting improvement in the overall risk profile of bank balance sheets may augment both the willingness and the ability of banks to lend.
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6.2 Overview of Central Bank Measures The central banks responses can be divided into three board types according to how the associated operations are related to their near objectives, figure 6.180. The first category response implies measures to ensure that the market rate is near policy rates (or target rates) through more active reserve81management, accordingly assuring banks of their orderly access to overnight funds. The second category consist initiatives to alleviate strains in general interbank markets i.e. term markets and repo market by increasing the average maturity of refinancing provided to banks, expanding, where needed, the range of eligible collateral and counterparties, and increase the scope of securities lending etc. The last two categories, insofar as they involve operations directed at particular segments of the transmission mechanism over and above the traditional interest rate target, fall under the umbrella of balance sheet policy (BIS (2009abc): 97).
80 See Appendix 9, for the third category. As the third category consist of responses intended at supporting specific credit markets, in particular the non-bank segments, and easing financial conditions more broadly, which is out of the scope of this paper, hence this last part of interventions do have a significant link to the following government interventions that had an overall impact on boosting the confidence between banks, and therefore perceived as an important aspect. 81 For instance, the three central banks, Fed, ECB and BoE, impose an average reserve requirement on banks. This contains that the banks must maintain a certain average minimum deposit at the CB for a reserve maintenance period of about one month in the ECB and BoE and of two weeks in the Fed. The purpose of imposing reserve requirements is to stabilise the overnight interest rate. This provides the banks an incentive to lend liquidity in the money market when the overnight interest rate is high compared to the interest rate on the deposits in reserve requirement accounts. Alternatively, the banks have the incentive to maintain sufficient reserves in periods when the overnight interest is low. Concerning the BoE, the banks have the option to determine, within certain limits, the size of their reserve requirements and change them from month to month (Danmarks Nationalbank (2008-1.Q): 39-40).
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Figure 6.10 Central Bank Responses to the Crisis
Objective Adopted Measures Fe EC Bo Bo Bo RN SN d B E J C B B Achieve the Exceptional fine-tuning operations X x1 x x X x x Official Change in reserve requirements x2 Stance of Narrower corridor on overnight rate 3 Monetary X X x 4 Policy Payment of interest on reserves X x Increased treasury deposit X X Short-term deposit or central bank bill X x x x x Interbank Modification of discount window facility X5 x Market Exceptional long-term operations X X6 x x X x X Conditions Broadening of eligible collateral X X x x X x X Broadening of counterparties X x x X X Inter-central bank FX swap lines X x x x X x X Introduction to increasing of conditions for X x x X securities lending Source: (BIS (2009-79th): 97; BIS (2008-No.31): 6). Notes: Fed = Federal Reserve; ECB = European Central Bank; BoE = Bank of England; BoJ = Bank of Japan; BoC = Bank of Canada; RBA = Reserve Bank of Australia; SNB = Swiss National Bank. _ = yes; blank space = no. 1) Including front-loading of reserves in maintenance period. 2) Expand range over which reserves are remunerated. 3) Lower the discount rate relative to the target federal funds rate. 4) Pay interest on excess reserve balances (Complementary Deposit Facility). 5) Reduce rate and expand term on discount facility; allow participation of primary dealers (Primary Dealer Credit Facility). 6 Including fixed rate full-allotment operations.
6.2.1 Achieving the Official Stance of Monetary Policy The operational target for central banks is to ensure that the overnight money market interest rate reflects the official interest rate (Danmarks Nationalbank (2008-1): 29). At the onset of the crisis, there was observed a strong increase in demand for central bank liquidity i.e. central bank reserves, hence as the crisis unfolded, commercial banks desired increased liquidity beyond central bank s was capable of (IMF (2008): 99). Thus, central banks mainly intended at defy the unstable demand for central bank reserves and this keeping money market rates in line with policy targets. In particular, RBA, BoC, ECB82, BoJ, SNB, the Federal Reserve and, from September, the BoE conducted market operations83 that were either outside their regular schedule i.e. fine tuning or in large than usual amounts84 (Danmarks Nationalbank (2008-1): 46); BIS-No.31 (2008): 23)85.
82 In general, the Eurosystem has disposal a set of monetary policy instruments available to achieve its objectives. The Eurosystem conducts open market operations, offers standing facilities and requires credit institutions to hold minimum reserves on accounts with the Eurosystem. The main objective of the Eurosystem is to maintain price stability, as defined in Article 105 of the Treaty (ECB (2008t): 7). See Appendix 10, for these policy instruments, and the several Fed programs that have been implemented. 83 In the period from 9 August and the following next five days, SNB, ECB, BoJ, Fed conducted overnight fine tuning operation for CHF 1.4 bn, EUR 212 bn, JPY 1 trillion, USD 38 bn respectively. The supply of Fed, 10 August 2007 has been the largest volume since September 2001. It is noteworthy that BoE did not increase the liquidity supply until the reserve maintenance period started in September when banks chose to raise their reserve targets. (Danmarks Nationalbank (2008-1): 46); (BIS-No.31 (2008): 23) 84 BIS (2008- No.31) state that overall, central banks did not inject more reserves than needed in order to maintain market rates near policy targets (BIS-No.31 (2008): 6). 85 Other means such a public announcements, assuring market participants of the accessibility of overnight standing lending facilities and accommodating a higher level of reserves holding, were also applied to help contain overnight rate volatility and to balance the supply of and demand for central bank reserves at the policy rate. See appendix X, for further detailed information for the step by step actions taken by various central banks
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After an intermeeting statement on 17 August 2007 that downside risks to growth had increased substantially, the Federal Open Market Committee (FOMC)86 cut the federal funds target rate by 50 basis points to 4-3/4 percent at its meeting in 18 September 2007 (Federal Reserve System (2007mn): 1). As shown in figure 6.2, over the following seven month i.e. from October 2007 to April 2008, the FOMC lowered its target rate by additional 275 basis points and became two per cent 30 April 2008 (Federal Reserve System (2007mo, mp); 2008mq, mr, ms). Even though it was widely expected to tighten policy at the meeting in September 2007, in order to inflationary pressures, the 6 September 2007 the ECB Governing Council announced that it left the interest rates on the marginal lending facility and the deposit facility87 will remain unchanged at 4.00%, 5.00% and 3.00% respectively, as well as in subsequent months, referring to high level of uncertainty in the financial outlook (ECB (2007-PRa): 1). Similarly, the BoJ remained the uncollateralised overnight call rate around 0.5. per cent, and continued to monitor movements in the international financial markets as well as the global economic developments behind them (BoJ (2007-PRb): 1); BIS (2008-No.31): 10).
Figure 6.2 Policy Rates1, in per cent
The BoE remained the policy rate unchanged in September 2007, citing a recent easing in inflation and the call for monitor the evolution of both the price and quantity of credit, and reduced its policy rate by ¾ percentage point between December and April. The BoC also remained the policy rate i.e. Source: (BIS (2009-70th): 91, 93). theNote: operating 1) For the Federal band Reserve,for the target overnight federal funds rate rate; and for bank the ECB, rate interest at 4 rate¾ percenton the main in refinancing September operations; 2007, for despite the BoJ, target for the uncollateralised overnight call rate; for the BoE, Bank rate. For the RBA, target cash rate; for the BoC, target priorovernight expectations rate; for Sveriges of Riksbank,tightening, repo rate;and for began the Swiss to Nationalease policy Bank, midpointin 5 December of the three-month 2007 88Libor (BoC target (2007-PRc, range. PRd): 1). The SNB raised its target band for the three month Swiss franc Libor to 2.25-3.25 per cent
(BIS-No.31 (2008): 6). 86 The federal funds rate is the market-determined interest rate on overnight interbank loans (Checchetti (2008): 7). 87 The Eurosystem offers credit institutions two standing facilities: 1) Marginal lending facility in order to obtain overnight liquidity from the central bank, against the presentation of sufficient eligible assets; and 2) Deposit facility in order to make overnight deposits with the central bank. (ECB (2009)). 88 BoC announced that it lowered its target for the overnight rate by one-quarter of one percentage point to 4 ¼ per cent. Correspondingly, the operating band for the overnight rate lowered and the bank rate became 4 ½ per cent (BoC (2007-PRd).
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in 13 December 2007, whereas the policy remained on hold in the December 2007 and 13 March 2008 meetings89 (SNB (2007-PRcc): 1); SNB (2008-PRcc, PRcd): 1). When examining other economies, the financial market turmoil had a less affect in the outlook sufficiently to affirm an easier monetary policy stance. As shown in the figure 6.2, for instance, the RBA continued to increase its target cash rate several times between August 2007 and early 2008. 8 August 2007, the Board decided to increase the cash rate by 25 basis points to 6.5 per cent, while in 7 November 2007, it increased 25 basis points again to 6.75 per cent. This was repeated again 5 February where the rate increased by 25 basis points to 7.0 per cent (RBA (2007-PRcc): 1); RBA (2007-PRcd): 1); RBA (2008-PRcc): 1). As well as Riksbank which continued on its previous policy path i.e. raising its repo rate in late 2007, for instance, 30 October 2007, the board decided to increase the repo rate by 0.25 percentage points to 4 per cent, and 2 February 2008, the repo rate increased once again by 0.25 basis points to 4.25 per cent (Riksbank (2007-PRa, PRb): 1). However, as shown in figure 6.3, some central banks had substantially difficulties in maintaining the overnight interest rates close to their targets, with the start of the turmoil. In the US, vital injection of reserves to resist firming of rates early in the day on occasion resulted in marked softness in rates close to the business and on subsequent days in the same maintenance period. In contract, in August 2007, the BoE did not expand reserve supply, overnight rates became rather elevated90. (BIS-No.31 (2008) highlights a vital observation, as although numerous central banks had standing lending facilities to serve as a liquidity backstop, these facilities, in some situations only limited protection against upward pressure on money market rates. Especially, in the US due to stigma, there was limited use of the standing lending facility (discount window), even during periods in which interbank rates increased above the lending facility rate. This is shown by the left panel in figure 6.3.
Figure 6.11 Indication of Stigma
89 Additionally, as a respond to the upward pressure on the three-month Swiss franc Libor, the SNB lowered its repo auction rate in order to bring the Libor down to levels in line with the target band`s midpoint. 13 September 2007, the repo rate was lowered (The three-month Libor for Swiss francs, increased as high as 2.9 per cent), and came as a surprise to market participants. It had a substantial impact on the Libor and therefore on the effective stance of Swiss monetary policy (SNB (2007-PRcd): 2-3); BIS (2008-No.31): 10). 90 Given the volatile conditions at the time, the fluctuations of market interest rates around the policy rate targets of the central banks, in all major currency areas increased to varying degrees in the first weeks of the turmoil. Hence, over the following weeks, central banks were better to achieve control of the targeted market rates, by adjusting their operations (BIS (2008-No.31): 11).
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Source: BIS (2008-No.31): 12). Note: 1) In billions of local currency units; daily data for the ECB and the Bank of England, weekly averages of daily amounts outstanding for the Federal Reserve. 2) In per cent. 3) For the Federal Reserve, primary credit; for the ECB, marginal lending facility; for the Bank of England, lending facility.
It is further stated that stigma is in part of legacy of the days when discount window credit was provided at a subsidies rate and involved allowance and search. Possibly, stigma may exist due to borrowing at a penalty rate sends an adverse signal about creditworthiness that increase reluctance of banks to use the facility. As the figure illustrates, in contract to the US market, when examining the euro area stigma appears to be less of an issue. During the turmoil, there were no reported interbank trades at rates above the marginal lending facility (MLF) rate, and it has been observed that the facility was used as frequently as in more tranquil periods (Cecchetti (2008): 6).
Hence, (BIS-No.31 (2008) stresses that the perception of MLFs could be changed, in particular intense conditions. Examining the situation in UK, there were very few days in which the daily high in interbank rate reported by brokers exceeded the standing facility rate. However, anecdotal reports suggest that higher rates had been paid in bilateral deals and that stigma inhibited borrowing from the standing facility, especially after the provision of emergency liquidity assistance91 to Northern Rock, a mid-sized UK bank in 14 September 2007 (BoE (2008-Annex): 53); BIS-No.31 (2008): 11). Overall, although the reluctance on the part of counterparties to use standing facilities may in certain cases have complicated central banks efforts to keep very short term market interest rates under control. Central banks were quite able to achieve their operational objective of returning market interest rates close to their policy rate targets. In general, interest rate volatility decreased
91 According to paragraph 14 of the Memorandum of Understanding between HM Treasury, the Bank of England and the Financial Services Authority states: "In exceptional circumstances, there may be a need for an operation which goes beyond the Bank's published framework for operations in the money market. Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance in the UK economy." (Tucker (2009): 14).
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after the first month. Nevertheless, the stability of very short term rates remained vulnerable and central banks had to apply a more active attitude, in order to contain further occurrence of volatility, which is further elaborated on in the sections below (BIS-No.31 (2008): 11).
After Lehman Default After the default of Lehman Brothers, intense pressure was observed in the markers by weeks, as also shown in chapter 4, Libor-OIS spreads increased dramatically, which appeared as a threat to the stability of key financial institutions, and the overall economic activity (BIS (2009abc): 93). On 8 October 2008, central banks simultaneously announced cuts in their policy rates. The six major central banks agree to conduct the first round of coordinated rate action. Other central banks around the world also showed a similar trend, where rates where cut rapidly. The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent (Federal Reserve System (2008lol): 1). At the same time, ECB announced to reduce the interest rate on the marginal lending facility by 50 basis points to 4.74 per cent and to reduce the deposit facility by 50 basis points to 2.75 per cent (ECB (2008-PRlol): 1).
BoE also reduced the bank rate by 50 basis points to 4.5 per cent (BoE (2008-PRlol): 1). BoJ expressed its strong support of the of the policy actions conducted by the other central banks BoJ (2008-PRlol): 1). The SNB decided to ease conditions by 50 basis points in a bid to decrease the Swiss franc three-month Libor from 3 per cent to 2.5 per cent. Furthermore, the target range was reduced to 2-3 per cent (SNB (2008-PRlol): 2). Riksbank decided to cut the repo rate by 50 basis points to 4.25 per cent as part of the joint announcement (Riksbank (2008-PRlol): 1). The BoC also announced to lower its target for the overnight rate by 1.5 per cent point to 2.5 per cent, and the operating bank for the overnight rate was lowered correspondingly, and the Bank rate to 2 ¾ per cent (BoC (2008-PRlol): 1). By the end of May 2009, the Federal Reserve, the BoJ, the BoE, the BoC, Sveriges Riksbank and the SNB had brought policy rates close to zero. The European Central Bank lowered its main policy rate by 3¼ percentage points between September 2008 and May 2009, but stopped well before it reached the zero lower bound. The sufficient supply of central bank balances from late 2008 and onwards pressed overnight rats close to the rate on the ECBs deposit facility, and almost to zero. Central banks stopped easing once policy rates reached levels slightly above zero, as usually bank deposit rates are below money market rates, the former may reach zero even if the latter are still
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positive. Banks needs to maintain a margin between deposit and lending rates to remain profitable (BIS (2009-79th): 93)92.
Narrower corridor on overnight rate In order to keep the short term rates to the policy target, the ECB, BoE and the Federal Reserve reduced the width of the effective corridor on overnight rate by changing the rates applied on end of-day standing facilities. For instance, 15 December 2008, the Federal Reserve announced a 75 basis point decrease in the discount rate93 to ½ per cent, and earlier the day, the FOMC decided to lower the target for the federal funds rate from 1 percent by establishing a target range of zero to ¼ per cent (Fed (2008-PRlok): 3)94. Furthermore, as of 9 October 2008, the ECB reduced the corridor95 of standing facilities96 from 200 basis points to 100 basis points on the interest rate on the main refinancing operation (ECB (2009-MB-Aug): 114). Simultaneously, central banks expanded their capacity to reabsorb excess reserves to neutralise the impact on overnight interest rates of the much expanded operations. This has been implemented in a number of ways, reflected in the composition of central bank liabilities in figure IV497, where an increase in the liabilities in particular after 2008. The BoE and the SNB initiated to issue central bank bills, whereas the ECB and the RBA preferred highly to rely on accepting interest bearing deposits. The Federal Reserve, accepted greater amount of deposits from the Treasury, and began to pay interest on reserves, which is usually not the case (Cecchetti (2008): 7).
In overall, although central banks had substantial accomplishment in keeping very short term interest rates in line with their policy rate targets, it was rather more difficult to assess the defined effect of central bank interventions in addressing funding market pressures. A very important observation has been that central bank interventions have not been able to eliminate the tensions and did not manage to prevent tensions from returning subsequently, at least in the early stages of
92 BIS (2009abc) states that financial market tensions and the increase in credit and liquidity risk premia impaired the program mechanism. For instance, yields on corporate bonds increased despite sharp declines in policy rates. Generally, banks passed reductions in their funding costs on to their customers, but tightened credit standards vitally, offsetting the impact of cuts in the policy rate on overall financial conditions (BIS (2009abc): 94). 93 Banks can usually borrow from the Fed at what it is called the Primary Lending Rate, also commonly called the discount rate (cecchetti (2008): 7). 94 Since January 2003 there has been a change in the procedure, the primary lending rate has been set at a premium above the target federal funds rates. Before to the start of the crisis in 2007, the premium was one percentage point, or 100 basis points. As the bank can be qualified and is willing to pay the penalty interest rate, it can get the loan (cecchetti (2008): 7). 95 The interest rates on the marginal lending and deposit facilities normally provide a ceiling and a floor for the overnight market interest rate (ECB (2009). 96 The Governing Council of the ECB, also decided that as of 21 January 2009, to re-widen the corridor of standing facility rates, symmetrically to 200 basis points (ECB (2009-MB-Aug): 203). 97 See Appendix 9, for figure 9.3, Central Bank Assets and Liabilities, in billions of respective currency units.
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the crisis. According to BIS (2008-No.31) this relies in the underlying reasons of term money market tensions. As tensions were caused by liquidity issues, in principle this would be addressable by central bank interventions, in order to improve the supply and distribution of liquidity. Hence, if the underlying reasons were driven by counterparty credit risk concerns the central bank liquidity operations would have been unable to weather the problem, which have been the case, in the early stages of the crisis at least.
6.2.2 Influence Wholesale Interbank Market Conditions These measures applied is quite prominent during the initial stage of the crisis, as they focused on reducing term interbank market spreads, which was fairly high as shown in chapter 4. In order to improve the continued pressure in term money markets, central banks took two main approaches i.e. referred to as the indirect and direct methods.
6.2.2.1 Indirect Approach The indirect approach aimed to reassure financial institutions of the sufficient supply of overnight funding. This approach aimed to increase the institutions willingness to extent term loans in the market by increasing the confidence in the financial institutions ability to fund themselves reliably in the overnight market. Along with the above mentioned liquidity management measures to keep short term market rates stable around policy targets contributed to this effect. The move by the Fed to enhance the attractiveness of its standing loan facility was also a step in this direction. The spread between its lending rate (the discount rate) and the federal funds rate target was narrowed from 100 basis points to 50 basis points in mid- August 2007, and then to 25 basis points in mid-March 2008. Moreover, the maximum allowable term on such loans increased from overnight to 30 days, and subsequently to 90 days.
6.2.2.2 Direct Approach The direct approach intended to increase the provision of term funds through market operations. In August 2007, the ECB started to conduct supplementary three month refinancing operations and in 28 March 2008 announced two six month refinancing operations to be conducted in April and July. 2 April 2008, ECB conducted the first supplementary six month to supply EUR 25 billion and, in 9 July 2008, conducted a supplementary three month of EUR 50 billion (BIS-No.31 (2008): 36-37, 40). In 13 September 2007, the SNB conducted its first three-month repurchase transaction, and offered other term transactions as needed in the subsequent months. A similar trend was observed in the RBA, the BoJ, the Federal Reserve and the BoE as they also expanded their provision of term
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funds. The contribution of the ECB and SNB in supplying term US dollar funding in coordination with the new Term Auction Facility of the Fed was an innovative variation on the same theme.
Modification of Discount Window Facility and Term Auction Facility (TAF) In an effort to lower the unusual term lending spreads as shown in chapter 4, the Fed took a range of actions98, besides lowering the spread between the discount rate and the fed funds target. The discount window99 is a traditional tool of Fed, which assist to relieve liquidity strains for individual depository institutions and the banking system as whole, by providing source of funding in time of need. Since 2003, depository institutions have had access to three types of discount window credit i.e. primary, secondary and seasonal credit100 (Fed (2009-MR): 7); Cecchetti (2008): 7).
On 12 December 2007, the Federal Reserve announced the introduction of the Term Auction Facility (TAF)101 which provides one-month loans against discount window collateral to a very wide range of banks, through biweekly auctions, along with the above mentioned coordinated actions by other central banks (Federal Reserve System (2007LL): 1). The TAF program102 allows eligible financial institutions in sound financial conditions to make bids for term borrowing from the Fed, with maturities typically of 28 days or 35 days, instead of overnight (Wu (2008): 5); Taylor and Williams (2008a): 24). From late December 2007, two TAF auctions have been held each month. The spread between the TAF rates and the OIS rate at the time bids were taken averaged approximately 50 basis points for the first two auctions, but then decreased in subsequent auctions, before rising again to around 40 basis points in the first auction of March 2008 (Taylor and Williams (2008a): 24-25).
98 Other measures aiming to improve the accessibility to market liquidity in a broader sense were taken into reflection. E.g. in order to promote the orderly market functioning of repo markets, the Federal Reserve designed two new facilities for primary dealers in the mid-March 2008 i.e. the Term Securities Lending Facility (TSLF) The Primary Dealer Credit Facility (PDCF) (Federal Reserve System (2007Lk). In the TSLF, primary dealers can borrow US Treasury securities for up to 28 days against certain agency-guaranteed and other high-quality private MBS, additionally to collateral eligible for usual OMOs. Whereas the PDCF offers primary dealers overnight discount window loans against certain investment grade debt securities as well as collateral for regular OMOs (BIS-No.31 (2008): 7).). Wu (2008) stress that these two facilities had less effect on the Libor-OIS spreads. Hence, this will not be further explained as its out of the scope of the paper. 99 The general policies that govern discount window lending are set forth in Regulation A of the Board. 100 Primary credit is available to generally sound depository institutions with few administrative requirements. Second credit may be provided to depository institutions that do not qualify for primary credit, subject to review by the lending Reserve bank. Seasonal credit provides short term funds to smaller depository institutions that face regular seasonal swings in loans and deposits (Fed (2009-MR): 7). 101 Under the TAF program, the Federal Reserve will auction funds to all depository institutions i.e. institutions with reservable deposits, commercial banks, saving and loans, savings banks and credit unions, as well as to US branches and agencies of foreign banks, against the wide variety of collateral that can be used to secure loans at the discount window. Most securities and loans on the books of depository institutions include assets denominated in the major foreign currencies and many asset booked abroad (Federal Reserve System (2007LL): 1). This program in contract with regular open market operations (OMOs) , which are conducted with the 20 primary securities dealers only and against a narrower set of collateral i.e. Treasury or US government agency securities including agency guaranteed Mortgage Backed Security (MBS) (BIS-No.31 (2008): 7). 102 The initial amount set for each auction was $20 billion and was then increased to $30 billion in January 2008 and $50 billion in March 2008 (Wu (2008): 5).
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In 21 April 2008, the BoE introduced the Special Liquidity Scheme, a facility in which banks can swap high-quality but temporarily illiquid assets for UK treasury bills. The asset swap can be undertaken at any point within a six month drawdown period and have terms of one year (renewable to up to three years). As only legacy assets existed as of end 2007 are eligible for the swap, the scheme aimed to improve the liquidity position of the banking system and not to finance new assets (BoE (2008ab); BoE (2008ac); BIS-No.31 (2008): 7). The Special Liquidity Scheme designed by the BoE was also received well by market participants (BIS-No.31 (2008): 12-14).
6.3 The Effectiveness of the Term Auction Facility (TAF) Regarding the effectiveness of the TAF has been quite different in the literature. According to Wu (2008), the empirical findings suggest that the TAF had strong effects in relieving the liquidity concerns in the interbank market, yet has little effect in lowering the counterparty risk premiums among major financial institutions. As the figure 6.4 illustrates, the one-month Libor spread over the OIS rate fell rapidly from the peak of 111 basis points in early December 2007 to below 30 basis points in late January 2008 (Taylor and Williams (2008a): 26); Wu (2008): 6); McAndrews et al. (2008):17).
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Figure 6.12 Introduction of TAF Auctions and Libor –OIS Spreads
Source: (Taylor and Williams (2008a): 26). Note: Due to unavailable data for the rest of the time period i.e. April 2008 to March 2009, will not be presented.
The vertical lines in the figure, depicts the dates of the TAF auctions, along with the one-month and three month maturities. Subsequent to the first two auctions, the TAF rate has been between 4 and 16 basis points below the prevailing one-month Libor rate. Yet, Wu (2008) stress that TAF, on average, reduced the one-month Libor -OIS spread by at least 31 basis points, and the three-month Libor OIS spread by at least 44 basis points (Wu (2008): 2, 18). Hence, the spread widened once again in early March 2008 to around 60 basis points and continued to increase 80 basis points in mid April (Wu (2008): 6). Dudley (2009) and Taylor and Williams (2008), it is important to stress that, the effect of the TAF, is not to increase the amount of total liquidity in the funding markets. As an increase in liquidity that comes from banks borrowing from the Fed utilising the TAF would be offset by open market sales of securities by the Fed to keep the total supply of reserves from falling rapidly. The Fed must sell securities to keep the federal funds rate on target (Taylor and Williams (2008a): 28); (Dudley (2009): 3). However, according to Fed (2009-MR) credit provided to depository institutions through the discount window and TAF has continued, primarily reflecting reductions in loans outstanding under the TAF. It has further been reported that the TAF auctions have been undersubscribed and as a result, the auction rates has been equal to the minimum bid rate of 25 basis points for some time. In addition, the August TAF auctions have been reduced in size to $100 billion from $125 billion in July. It has been anticipated by the Federal Reserve that the sizes of TAF auctions will gradually be reduced if market conditions continues to improve (Fed (2009-MR): 7).
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Eligible collateral Another very crucial development that various central banks engaged in was to widened, either temporarily or permanently, the range of eligible collateral and, in some situations counterparties so as to provide an effective distribution of central bank funds. E.g. in August 2007, the BoC announced special operations that accepted temporarily as collateral all securities that were already eligible for its standing liquidity facility (SLF). In December and early 2008, this was followed by term repo operations that accepted a wider than normal range of collateral103 (BoC (2007abc); BIS
No.31 (2008): 7). In mid-August 2007, SNB also announced a similar expansion of its eligible collateral list with effect from 1 October as an indirect response to the turmoil (SNB (2007aa): 1). In late September and October 2007, the BoE offered four special three-month tenders against a wider range of collateral and to a wider set of counterparties. In December (2007) as part of the coordinated central bank interventions, the BoE also announced its widened collateral list and that it
104 increased the size of its standard three month repo operations (BIS-No.31 (2008): 7); (BoE (2007aa): 1-2). A comparable characteristic for all regular discount and TAF loans is that they must be fully collateralised to the satisfaction of the lending Reserve Bank, with an appropriate “haircut” applied to the value of the collateral105. It is to be emphasised that collateral plays a vital role in mitigating the credit risk associated with these extensions. The Federal Reserve generally accepts as collateral for discount window loans and TAF credit any assets that meet regulatory standards for sound asset quality. The table 6.1 below shows the lendable value of securities pledged by depository institutions by rating, as of 29 July 2009. As it can be seen, in particular, AAA securities had been lent out, at a value of $205 billion, followed by secured securities such as US Treasury etc, and other investment grade, which is based on credit review by the Reserve Bank. This also shows the need for securities with high credit rating, in order to ensure no default in payments.
103 For instance, the RBA also widened the list of collateral eligible for its regular repo operations from September 2007, and its overnight repo facility to include a more broad range of bank paper as well as RMBS and ABCP (RBA (2007a)). 104 The widened collateral list also includes AAA-rated RMBS and covered mortgage bonds (BoE (2007aa): 1-2). See Appendix 11, for the full list of collateral for BoE and for ECB see https://mfi-assets.ecb.int/dla_EA.htm. 105 In extending credit to depository institutions, the Fed closely monitors the financial conditions of borrowers, by employing the internal rating system, which provides the framework for identifying entities that may pose undue risks to the Fed. Note: The monitoring of the financial condition is a four step process, designed to minimize the risk of loss to the Fed. The first step is monitoring the ongoing basis, the safety and soundness of all depository institutions that access or may access the discount window and other services provided by the Fed. The second step is identifying institutions whose condition, characteristics, or affiliation would match higher than acceptable risk to the Fed in the absence of controls on their access to Fed lending facilities. The third step is communicating relevant information regarding those institutions identifies as posing higher risk. The fourth step is implementing appropriate measures to mitigate the risks (Fed (2009-MR): 7-8)
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Table 6-1 Lendable Value of Securities Pledged by Depository Institutions by Rating, As of 29 July, 2009
Type of Securities Lendable Value ($ billions) U.S. Treasury, agency, and agency-guaranteed securities , and Other securities 139 AAA 205 Aa/AA1 46 A2 66 Baa/BBB3 31 Other investment grade4 104 Total 591 Source: (Fed (2009-MR): 9). Note: Lendable value is value after application of appropriate haircuts. 1) Includes short-term securities (STSs) with A-1+ rating or MIG 1 or SP-1+ municipal bond rating. 2). Includes STSs with A-1 rating or SP-1 municipal bond rating. 3). Includes STSs with A- 2, P-2, A-3, or P-3 rating. 4). Determined based on credit review by Reserve Bank.
Fed (2009-MR) stress that the category of assets includes most performing loans and most investment grade securities, including CMBS, CDO, CLO, and certain non-dollar denominated foreign securities, only AAA rated securities are accepted. Hence, institutions may not pledge as collateral any instruments they have issued. Additional collateral is required for discount window and TAF loans with remaining maturity of more than 28 days- for these types of loans, borrowing solely up to 75 per cent of available collateral is permitted (Fed (2009-MR): 9).
BIS-No.31 (2008) argues that it was difficult to disentangle the effects of the various reasons for the central banks in the beginning of the turmoil. As the purpose of the central bank interventions was to address the term money market tensions, BIS-No.31 (2008) questions whether central banks had completely satisfied the relevant demand. Especially, the central bank offers term funds were in many cases keenly taken up resulted in elevated auction stop out rates, suggests that the operations only have met the underlying funding needs partly. Despite matters regarding the volume of term fund providing operations, there was evidence, in particular subject to the array of eligible collateral assisted alleviate the fallout from the common illiquidity in credit markets. In given situations, private sector counterparties were in some events keen to finance their less liquid collateral with the central bank (BIS-No.31 (2008): 13).
Swap Lines Another very significant was the establishment of inter central bank swap lines to alleviate mostly dollar funding pressures, which was the reason to the spill over to the FX swap market. This was a joint establishment by notably central banks i.e. The Federal Reserve, the European Central Bank, the Swiss National Bank. As the US dollar shortages of European financial institutions did not show any signs of improvements, in December 2007, the Fed, the ECB and the SNB- for the first time in
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its history, responded in a coordinated manner to address the US dollar shortage these financial institutions were facing (Baba & Packer (2009-No.285): 5); SNB (2009): 20). In order to improve the functioning of the year- end concerns in the financial market by providing liquidity, the Federal Open Market Committee (FOMC)106 announced the establishment of temporary swap lines, or “reciprocal currency arrangements”, with the ECB, the SNB, the BoE and the BoJ in 12 December 2007107, which aims to provide liquidity in US dollars to overseas markets (SNB (2009): 20); FRBNY) (2008): 2); ECB (2008): 12, 82).
These swaps involve two transactions i.e. when a foreign central bank draws on its swap line with the Fed, the foreign central bank sells a particular amount of its currency to the Fed in exchange for dollars at the prevailing market exchange rate. At the same time, the Fed108 and the foreign central bank enter into a binding agreement for a second transaction that obligates the foreign central bank to buy back its currency on a specified future data at the same exchange rate. The second transactions undo the first, and at the end of the second transactions, the foreign central bank pay interest, at a market-based rate, to the Fed (Federalreserve.gov (2009)). As of 31 December 2008, total dollar liquidity to foreign central banks was $554 billion, hence as of 29 July 2009 this dropped to $88 billion (Fed (2009-MR): 5). According to McGuire and Peter (2009), the quantities of US dollar distributed, illustrated by the figure below, may provide an indication of the US dollar funding shortfall of European banks`. As figure 6.5, shows the US dollar lending in the Eurosystem and the Swiss National bank froze in the first quarter of 2008. Hence, in the third quarter of 2008, there has been observed an increase in the US dollar lending, in particular in the Eurosystem and Bank of England, whereas the amount has been smaller in the Swiss National Bank.
106 At the same time, the FOMC also approved new facilities with the Reserve Bank of New Zealand (RBNZ), Banco Central do Brasil, Banco de México, the Bank of Korea, and the Monetary Authority of Singapore (FED (2008-PRab). 107 These activities were the first established since 11 September 2001, when swap agreements devoted to assist financial market functioning after the disruptions to infrastructure due to the terrorist attacks (Baba & Packer (2009-No.285): 5). 108 The Fed keeps the foreign currency in an account at the foreign central bank. The dollars that the Fed provides are deposited in an account that the foreign central bank maintains at the Federal Reserve Bank of New York.
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Figure 6.5 US Dollar Swap Lines of Key Central Banks, in billions
At the time, the terms of the features of the agreement, the ECB could swap euro for up to $20
billion,Source: (McGuire and the and SNB Peter could (2009): Swiss59). francs for up to $4 billion, respectively, through the end of June 2008 (Baba & Packer (2009-No.285): 5). As the figure depicts, these US dollar swap lines became unlimited to accommodate any quantity of US dollar borrowing (against collateral), for the participants in the market in 13 October 2008. This explains the observed increase mention above. With these funds, the ECB and SNB were then able to temporarily lend, through auctions conducted in parallel with the Term Auction Facility (TAF) of the Federal Reserve (as mentioned in Chapter 4), the dollar proceeds of swaps to Eurosystem and Swiss counterparties with in need of term dollar funding. On 17 and 21 December 2007, the ECB carried out fixed rate auctions for $10 billion of 28 day and 35 day funds, respectively, were the rates was determined by the marginal rate of the same day of Federal Reserve TAF auction. While, 17 December 2007, the SNB held a variable rate tender auction for $4 billion. All of the auctions were completely subscribed, and therefore, by the end of the year, both the ECB and SNB had entirely drawn down their swap lines with the Federal Reserve. These auctions were followed by analogous ones, which essentially rolled over the 28-day swap lines by the ECB in 14 and 28 January 2008, and by the SNB of 14 January. Hence, as the term funding pressures declined in February (as mentioned in chapter 4), along with the FX swap market deviations, the auctions were consequently suspended by the ECB and SNB, and thus not held in February 2008 (SNB (2009-Appendix); Baba & Packer (2009-No.285): 5). When examining the effect of swap lines in the balance sheets, as illustrated in figure 9.3 in appendix 9, the establishment of the swap lines was a vital driver of balance sheet expansions for major central banks during this period. The value of FX swap was higher in the Federal Reserve in mid 2008, and started to decrease again, when nearing year 2009. A similar pattern was observed in BoE and European system hence the value for FX swap was higher in the BoE compared to the European system.
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6.3.1 Effectiveness of the Swap Lines As mentioned earlier, as the dollar liquidity matter for European banks turned into a global issue, in particularly, after the Lehman default, central banks stepped in to release the market. A number of authors have examined the effect on the CIP. Hui (2009) examines the effect of the Federal Reserve Swap lines with other central banks on the FX swap spread. The study suggests that the Federal Reserve Swap lines reduced the FX swap spreads in the three European economies, and Japan after the Lehman failure, whereas the impact of the Federal Reserve dollar swap lines with the European Central Bank and Swiss National bank on the corresponding FX swap spreads before the Lehman failure was insignificant (Hui (2009): 10). A relative study by Baba and Packer (2009b) also find that the US dollar term funding auctions provided by different central banks and the unlimited dollar swap lines designed by the US Federal Reserve had stabilising effect on the CIP deviations (Baba and Packer (2009b): 18).
6.4 Cooperation with Fiscal Authorities Taylor (2009) stress that the increased spreads in the markets were perceived by authorities as liquidity issues, therefore the early interventions focused mainly on policies other than those which would deal with fundamental sources of heightened risk (Taylor (2009): 11). As also mentioned earlier in the footnote, the third category of policy responses received more prominence as the later stages of the turmoil, and thus, it focused on alleviating tightening credit conditions (BIS (2009abc): 101), which indicates that the reason for central banks not being able to prevent tensions from returning, may have been that they have not been focusing enough on the credit risk involved in the spreads observed in chapter 4. The central bank interventions addressed the immediate funding needs banks were facing in the first stages of the crisis, but with the bankruptcy of Lehman Brothers in mid- 2008 called into question the solvency of a range of vital financial institutions109. Given their significance to the functioning of the real economy, many governments took actions to prevent their collapse and to restore confidence in the financial system110. According to BIS (2009abc) the government policy response had a positive effect in preventing the collapse of the financial system, and calming the markets.
109 For instance, issues related to the UK mortgage lender Bradford & Bingley, which became nationalised; banking and insurance company Fortis receives a capital injection from three European governments; German commercial property lender Hypo Real Estate secures a government-facilitated credit line; troubled US bank Wachovia is taken over; the proposed TARP is rejected by the US House of Representatives. 110 The fact that central banks have relied on balance sheet policies (see figure Central Bank Assets and Liabilities..) has entailed a rapidly persistent role for the central bank in the intermediation process, and more remarkable influence on the relative supplies of claims on the public sector. Consequently, this has increased the need for close cooperation with the fiscal authorities for two chief reasons. First, large purchases of government securities and the associated rapid expansion of central bank liabilities affect the overall profile of public sector debt. This could result in damaged by debt management operations due to their usually large size, except the objectives of the two types of operations are consistent. The second reason is that central banks take on greater credit and market risk. As a consequence, a close relation between the central bank and the government is necessary, in order to ensure that potential losses do not impair the operational independence of central banks (BIS (2009-79th): 100-4).
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However, it had less success in convincingly addressing the impaired assets on the balance sheets of the banks, which also indicate a delay of adjustments required to ensure that the financial system can operate efficiently on a sustainable basis.BIS (2009abc) stress that by May 2009, doubts about the long term health of major global banks remained, with uncertainty regarding potential losses from loan books and other credit exposures making it difficult for banks to raise private capital.
6.4.1 Characteristics of government rescue packages
In late September 2008 and in October 2008, governments of most lending economies, as shown in the table below announced comprehensive rescue packages. It was further stated that no vital institution would be allowed to fail (direct.gov.uk (2009); bundesregierung.de (2009); usa.gov/ (2009). This is an attempt to boost some confidence in the overall market. BIS (2009-79th) stress that the rescue packages consist of actions aiming the liquidity and solvency of specific institutions and the functioning of financial markets, as illustrated in figure 6.6. In contrast to the central banks had provided short term funding to eligible institutions during earlier stages of the crisis, while government provided access to more permanent sources of funding in the deepen period of the crisis by providing deposit and debt guarantees. Governments solved issues related to solvency by recaptilising the banks, and in an effort to address impaired assets, governments either purchased assets or provided insurance against extraordinarily large losses on particular portfolios of key institutions. Finally, central banks along with the governments have played a fundamental role in calming and stabilising the interbank market as well as the overall financial markets. Central banks have adopted a range of policies to respond to the crisis, these can be divided into three board types. The first category response implies measures to ensure that the market rate is near policy rates (or target rates) through more active reserve management, accordingly assuring banks of their orderly access to overnight funds. The second category consist initiatives to alleviate strains in general interbank markets i.e. term markets and repo market by increasing the average maturity of refinancing provided to banks, expanding, where needed, the range of eligible collateral and counterparties, and increase the scope of securities lending etc. The last two categories, insofar as they involve operations directed at particular segments of the transmission mechanism over and above the traditional interest rate target, fall under the umbrella of balance sheet policy Figure 6.13 Special Government Tools to Stabilise the financial system1
Tools/ Government US GB DE FR IT NL CH AU CA JP
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Deposit insurance x X X x x x Restriction on short selling x X X x x X x x x Capital injections x X X x x x x x Debt guarantees x X X x x x x x x Asset insurance X X x Asset purchases X X X x x x x Nationalisation X X X x Source: (BIS (2009abc): 103). Note: US = United States; GB = United Kingdom; DE = Germany; FR = France; IT = Italy; NL = Netherlands; CH = Switzerland; AU = Australia; CA = Canada; JP = Japan; x = yes; blank space = no. 1 Reflects information up to end-April 2009.
As a last remedy, governments even nationalised insolvent financial institutions to protect depositiors and avoid contagion, or acquired majority equity stakes. More than 20 countries increased guarantees on retail and commercial deposits, reducing the probability of bank runs. Government debt guarantees allowed eligible banks to issue new bonds supported by explicit government assurance in return for an annual fee paid by the issuer. Issuance under these schemes was the primary source of bank bond issuance in the last quarter of 2008 and the first quarter of 2009. The market response to the government debt guarantee programs was slower than expected as issuers were discouraged by the terms and the costs. For instance, European banks faced higher costs for debt guarantees compared to US banks, while the US charged a flat rate to all borrowers regardless of rating. The cost of European guarantees was connected to past CDS spreads making them more expensive for riskier borrowers. In certain incidences, the involved costs, made guarantees less attractive than short term funding through central banks. The maturities available also varied by country, usually from three to five years, with most banks issuing at the longest maturity available. The complication related to the guarantees programs and the varying treatment across jurisdictions discouraged some investors111. Governments recapitalised the banks to reduce their financial leverage and increase their solvency. UK Treasury applied common shares, whereas most governments bought hybrid securities112 such as preferred shares or mandatory convertible notes. The government capital injections had issues attached. Certain conditions were difficult to enforce due to lack of precision and unwillingness or inability to interfere in the management of the banks. For instance, many rescue packages outlined general restrictions on executive pay, hence governments lacked votes, the support of the boards of
111 The risk weighting on government-guaranteed bonds varies across countries, with some regulators treating them as riskless from a capital perspective and others assigning a 20% capital charge. Not all markets accepted guaranteed debt as collateral. Some investors also faced legal or operational restrictions that prevented them from buying this new asset class. 112 However, hybrid securities are not perceived with much confidence by market participants due to their limited ability to absorb losses, even though they may qualify as equity when the regulatory ratio of a bank is calculated.
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the banks, and the legal basis to block payments. A small number of governments supported key financial institutions by purchasing impaired assets or offering insurance against losses. E.g. the SNB bought mortgage related assets from UBS and positioned them in a special investment vehicle113. The Dutch, UK and US governments also offered asset insurance to a few banks i.e. ING, RBS, Lloyds TSB, Bank of America and Citigroup114. BIS (2009abc) emphasise that by limiting the potential losses of the banks, asset insurance reduces the capital it must hold. However, the governments are left with a great possible liability given the assets fall to a large extent in value. At last, governments in Iceland, Ireland, the United Kingdom and the United States overtook a range of insolvent financial institutions to protect depositors and to prevent contagion to other financial institutions115 (BIS (2009abc): 100-106).
Market reaction to rescue packages According to BIS (2009abc) the government interventions in late September and October 2008 averted bankruptcies at key banks and protected depositors but did not entirely dispel health concerns of major global banks. Nevertheless, as also reflected in figure 4.5 there has been a narrowing of credit spreads, however, BIS (2009abc) stress that most banks still found it difficult or impossible to raise new capital from private investors. As a whole, BIS (2009abc) highlight that governments may not have acted promptly enough, government rescue packages reduced the probability of default, pushing down CDS premia on average (BIS (2009abc): 110).
113 The sale reduced the risk weighted assets of UBS, lowered the amount of regulatory capital it must hold against potential losses. Despite that fact SNB bears the risk of losses, it also shares in the profits if the assets recover. 114 These schemes involves; governments assume a share of the potential losses on a particular portfolio, generally 80-90 percent after a first loss amount (or deductible) is absorbed by the bank. In reply, banks pay the government an insurance premium based on the riskiness of the portfolio. 115 The control transfers was accomplished directly by regulators through e.g. US government sponsored enterprises and Icelands banks, or through court injuction, as was the case of Bradford and Bingley in the UL and the Belgo-Dutch firm Fortis. In other situations, it was accomplished indirectly by acquiring the majority or entirely of the voting shares such as with AIG and RBS. The legal set up for regulatory for takeovers exist already in the US, but new law have to be passed in Germany and UK to facilitate these actions, which in the other hand might be blocked by shareholders.
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CHAPTER 7: CHAPTER 7: PERSPECTIVE In April 2009, at the London Summit, the G20 gathered to discuss what was achievable at the international level in terms of financial supervision as no global bodies in the realm of financial supervision had any legal powers. G20 agreed principles for handling globally with impaired assets, repairing the financial system to restore lending, strengthening financial regulation to rebuild trust, and funding and reforming international financial institutions, both to overcome the current and to prevent future crisis. In an attempt of dealing with this, the new Financial Stability Board (FSB)116 was established with a supported mandate as a successor to the Financial Stability Forum, to extend regulation and oversight to all central financial institutions, instruments, and markets and to reinforce international standards of prudential regulation (House of Commons (2009): 45). Mario Draghi Chairman of the Financial Stability Forum, sums the objective of FSB 117 as to promote and assist to coordinate alignment of international standard setting activities to address overlaps or gaps in national regulatory structures relating to prudential and systemic risk, market integrity and consumer protection, infrastructure, and accounting and auditing. In addition, the FSB aims to set up regional outreach activities to broaden the circle of countries engaged in work to promote international financial stability. Furthermore, as a result, the FSB and IMF will collaborate closer, each complementing the role of the other. Those two bodies are to collaborate in conducting Early Warning Exercises and make a joint presentation to the International Monetary and Financial Committee (IMFC) on financial risks and vulnerabilities and policy recommendations to mitigate such risks (FSA (2009): 3).
At the London Summit, it was argued that the new global framework would be agreed at the EU level, and thereby highlighted the role of EU. Reforms to financial regulation have been presented by the report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière. In February 2009, the report proposed a new framework for European Supervision, to reduce risk and improve risk management, reduce procyclicality, improve systemic shock
116 The Financial Stability Forum (FSF) has been relaunched as the Financial Stability Board (FSB), with an expanded membership and a broadened mandate to promote financial stability. FSB emerged towards placing the FSF on stronger institutional ground to strengthen its effectiveness as a mean for national authorities, standard setting bodies and international financial institutions to address vulnerabilities and to develop and implement regulatory, supervisory and other policies in the interest of financial stability (FSA (2009): 1). 117 The following countries and territories are represented on the FSB: Argentina, Australia, Brazil, China, Canada, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Switzerland, Turkey, the United Kingdom, and the United States. The following institutions, standard-setting bodies and other groupings are also members of the FSB: the Bank for International Settlements, European Central Bank, European Commission, International Monetary Fund, Organisation for Economic Co- operation and Development, World Bank, Basel Committee on Banking Supervision, International Accounting Standards Board, International Association of Insurance Supervisors, International Organization of Securities Commissions, Committee on the Global Financial System, and Committee on Payment and Settlement Systems (FSA (2009): 3).
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absorbers, improve financial markets incentives, strengthen the coordination of supervision between national authorities and the establishment of crisis management procedures (House of Common (2009): 44). As a result of this, in June 2009 the European Council (EC) established the European Systemic Risk Board (ESRB)118, which will monitor and assess potential threats to financial stability and, where necessary issue risk warnings and recommendations for action and monitor their implementations (Council of the European Union (2009): 7); European Commission (2009PR): 8-9). Already in 2000, Andrew Crockett, the previous General Manager of the Bank for International Settlements and Chairman of the Financial Stability Forum, raised the need for supervisory policy limiting the possibility of the failure and corresponding costs, of vital portions of the financial system (Crockett (2000): 1).
Furthermore, three European supervisory authorities, dealing with the banking, insurance and securities industries, working close to national supervisors, among other things in preparing technical standards, ensuring consistent application of EU law and resolving disputes between national supervisors. The three new European Supervisory Authorities will replace the existing EU Committees of supervisors, which will be charged with ensuring that a “single set of harmonised rules and consistent supervisory practices is applied by national supervisors” (European Commission (2009PR): 11). Lord Turner of Ecchinswell, the Chairman of the Financial Services Authority, further states that the objective of the new bodies are to put pressure on the regulators in small countries to ensure tight standards are applied and not to dictate regulators in large countries such as the FSA what to do (House of Commons (2009): 46).
Lorenzo (2009) stress the importance of these reforms, especially against the background of the financial crisis that faced in the summer of 2007 (Lorenzo (2009): 1). The enthusiasms for the new body, ESRB was revealed by a remark by Lord Turner of Ecchinswell, the Chairman of the Financial Services Authority as the following; “Whether this body turns out to be a mere talking shop or a useful talking shop, in terms of an exchange of views and ideas being generated, remains to be seen—that is up to the people who sit on it. We will see. I go to vast numbers of international meetings and I cannot claim that most of them live up to the billing that one would hope. Nevertheless, as I said, hope springs eternal—cautious, moderate hope for this committee—and we
118 The members of the General Council of the ECB will elect the chair of the European Systemic Risk Board, which also means that the interest of the ECB will be persuade in these reforms (Council of the European Union (2009): 7).
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will do our best to try and raise the level of debate”(House of Common (2009): 44). This remark is quite interesting, as it mirror concerns in these types of international meetings, in particular with the new scale of work involved.
On 26-27 June, the FSB held its first inaugural meeting in Basel, since the re-establishment as the FSB119. The FSB established a Cross-border Crisis Management Working Group, under the Standing Committee for Supervisory and Regulatory Cooperation. The working Group is chaired by Paul Tucker, Deputy Governor of the BoE, who will work to provide a framework to implement the FSF Principles for Cross-Border Cooperation on Crisis Management (FSB (2009-PR): 2). For instance, in managing a financial crisis, authorities will endeavour to find internationally coordinated solutions that take account of the impact of the crisis on the financial system and real economies of other countries. Moreover, to share information freely as feasible with relevant authorities from an early stage, and if a fully coordinated solution is not possible, a discussion as promptly as possible. Finally, for the purpose of clarity and coordination, to share plans for public communication with appropriate authorities (FSB (2009): 3-4).
As also reflected in previous chapter, the FSB also mentioned signs of improvements in the global macroeconomic outlook and in certain financial markets, in particular funding markets (Fed (2009- Aug): 1). Banks have managed to raise capital from the private sector, but restricting and strengthening bank balance sheets is not yet completed. It is further emphasised that, in order to support sustained recover, bank lending needs to be strengthened. The FSB assigned a number of objectives since April 2009 e.g. it welcomed the IOSCO work to develop recommendations on regulatory approaches to securitisation and credit default swap markets. This is to be publicated in the IOSCO report in September 2009. Furthermore, national and regional initiatives are going on to strengthen oversight of credit rating agencies. In addition, the FSB is to publish later in this year, the work by the Joint Forum to analyse regulatory gaps and propose solutions, in order to ensure that the nature and scope of regulation across banking, insurance and securities markets are consistent and appropriate etc (FSB (2009-PR): 2).
119 At this meeting, the FSB set up the internal structures needed to fulfill its mandate, also risks and challenges facing financial systems was discussed, along with the progress of implementing FSb and G-20 recommendations (FSB (2009-PR): 1).
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CHAPTER 8: CHAPTER 8: CONCLUSION As a conclusion the thesis has described and analysed/discussed the tension in the international interbank and FX swap markets in the time period of 2007-2009, which was followed by a discussion of the role of the central bank actions. The thesis has said out underlying dynamics behind the tensions experienced in the international interbank and FX swap markets.
The Statistics part illustrated the measures for liquidity in the interbank markets, which has been reflected in the Libor-OIS spreads, and the term markets. Moreover, measures for credit spreads have been mirrored in the Five-year bank credit default swap (CDS) spreads for selected banks in the US, UK and Europe. The liquidity measure in the FX swap market has been reflected in the spread between FX swap-implied rates and Libor. All of the measures showed an increase in the spreads in August 2007, and a heightened increase in the fourth quarter of 2008, after the Lehman Brothers bankruptcy. On the 9 August the first signals were observed in the interest rate on overnight loans between banks, which increased unusually high levels for many international markets, such as the US, Europe, UK and Japan. The US, Euro, UK and Yen Libor- OIS spreads increased from 8 bps. to 123 bps., five bps. to maximum of 186 bps., from 6 bps. to 165 bps., and from 16 bps. to 73 bps., respectively, in the fourth quarter of 2008. When examined the unsecured and secured spreads, a similar pattern of increased spreads was observed after the default of Lehman Brothers. While, the term rates a pattern of higher activity in the short term rates, in contrast to the longer term rates. In the second quarter of 2008, overnight activities represented around 70 percent of the total lending and borrowing activity in the European unsecured market.
Furthermore, the statistics have shown credit default swaps spreads as a measure of default risk of banks in institutions in US, Euro area and the UK. The initial increased was observed already in July of 2007 where the spread was less than 100 bps. Hence, also in here, the first major increases occurred in 2008 for all the economies. The US spread was observed to be around 290 bps., whereas the Euro and the UK were less than 200 bps. Investigating the external environments, issues related to international financial institutions seems to play a role behind the high CDS spreads observed. A second spread occurred with the Lehman default, where the spread approximated 600 bps. in the US, whereas in the Euro area and the UK , the spread increased to around 200 bps., and 300 bps. respectively.
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Again the statistics showed the three- month, six-month and 12- month US funding rate implied from the FX swaps in EUR, GBP and JPY, which after 9 August 2007 showed an upward trend. The spreads between the FX swap-implied dollar rates and dollar Libor also increased, moving from July levels, i.e. close to 35 bps in the euro, 25 basis points in sterling, and 15 basis points in the yen. Anecdotal evidence suggest European financial institutions that needed US dollars, hence faced keen concerns over their own credit risk in dollar cash markets, turned to the FX swap market to raise dollars using both the euro and sterling as funding currencies, which was reflected in the FX swap price i.e. deviation from CIP condition.
Analysing the underlying dynamics observed in chapter 4, liquidity hoarding have been presented as a trigger for the tension in the interbank market, which eventually spilled over to short term FX swap markets. The majority of empirical studies support the fact that both factors i.e. credit and liquidity risk played a relevant role in the financial crisis 2007-2009 in the interbank markets, which was observed in chapter 4. It has been argued that if liquidity was the only explanation for the tension, central banks should have been able to quickly restore normal conditions by injections of great amounts of liquidity, and make the supply of bank reserves meet the level demanded by the banking system. Moreover, if credit risk were the only explanation, it would be difficult to explain the noteworthy differences across market segments, especially why the short term segment has been rather resistant from the crunch, and why banks should lend short term at normal rates, if it its believed that counterparty may not be able to repay.
Furthermore, funding sources switched from very short term borrowing, where the main majority of overall unsecured activity usually takes place, to secured longer term instruments, which suffered from a less severe liquidity strain than the unsecured interbank deposit segment. There has been a general decline in unsecured transaction volumes, hence an increase of 31 percent in borrowing transactions for maturities longer than one month.
It is stressed that a significant aspect of the turmoil was due to shortage of dollar funding for many institutions, in particular European institutions was the factor that triggered the spill over to the international FX swap markets. At the end of September 2008, the interbank markets were shut down, and banks sought dollar financing elsewhere.
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In the third quarter of 2008, the interbank lending continued to contract, also indicating the ongoing tensions in interbank credit markets. There has been observed a reduction of the interbank lending, in particular by French, Belgian and German banks, which accounted for much of the decline. French Banks reported a decline to around $250 billion, whereas German banks a bit less than $250 billion. These two banks were also those with the highest consolidated foreign claims compared to the Belgian banks, which only reported around $600 billion in the beginning of 2008, but suffered a decline in the foreign claims of around $100 billion. Furthermore, only a slight decline for the interbank lending for Swiss banks have been observed compared to the other European banks. Subject to this critical demand/supply conditions in the interbank market, many non-US financial institutions endeavoured to convert euro into dollar liquidity through FX swaps, one of the most liquid financial markets.
The underlying factors observed in the FX swap spread i.e. deviations from CIP conditions has been a great discussion. In the theoretical framework, it has been stressed that CIP to hold strictly depends on negligible, in particular with credit risk, liquidity risk measurements errors, transaction costs and political risk. Hence, as observed in chapter 4, liquidity and credit risk have played a significant role in the recent turmoil. Recent empirical studies have shown similar conclusions. It has been emphasised that deviations from the CIP in the Euro FX swap market has been due to reassessment of counterparty risk based on the data from August 2007 to September 2008. It is to be remarked that due to unavailable data after September 2008 is lacking in several studies. Hence, a more recent study finds that the early stage of the crisis i.e. prior to the Lehman default, for euro, pound, Swiss franc and yen, the funding liquidity was the major concern and main determinant of the changes in the CIP (measured by the Libor/OIS spread).
However, examining the time period after the default of the Lehman Brothers another pattern shows as explanation for the spread in the FX swap implied US dollar rates i.e. CIP deviation. The funding liquidity risk remained a vital factor behind the FX swap spread, despite a fall occurred in the explanatory power for the euro, pound, Swiss franc and yen. In addition, counterparty risk became a significant explanation factor, after the Lehman default in the European economies in the CIP deviations for euro, pound and Swiss franc, which increased the premiums on the swap implied USD interest rate.
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Due to very limited empirical studies other factors such as transaction costs, data imperfections have not been investigated with data from 2007-2009, and therefore, the effect on the crisis have not been able to be identified in more details. Furthermore, under turmoil there has been existence of short term deviations of CIP in the FX swap market, hence analysing the time frame for the spread in chapter 4, it was obvious that the spread took longer time than usual, as it is assessed that deviations in the Euro-market are in general eliminated within two days it can take up to several weeks for Canada and the U.S.
Finally, central banks along with the governments have played a fundamental role in calming and stabilising the interbank market as well as the overall financial markets. Central banks have adopted a range of policies to respond to the crisis, these can be divided into three board types. The first category of responses implies measures to ensure that the market rate is near policy rates (or target rates). The second category consist initiatives to alleviate strains in general interbank markets i.e. term markets, increasing the average maturity of refinancing provided to banks, expanding, where needed, the range of eligible collateral and counterparties, swap lines etc. Hence, government remedies were also enforced as a remedy to battle the credit risk in the overall market. Few governments supported key financial institutions by purchasing impaired assets or offering insurance against losses.
The market reaction on the government interventions in late September and October 2008 averted bankruptcies at key banks and protected depositors but did not entirely dispel health concerns of major global banks. Hence, government rescue packages reduced the probability of default, pushing down CDS premia on average
In April 2009, at the London Summit, the G20 gathered to discuss the global turmoil.G20 agreed principles for handling globally with impaired assets, repairing the financial system to restore lending, strengthening financial regulation to rebuild trust, and funding and reforming international financial institutions, both to overcome the current and to prevent future crisis. In an attempt of dealing with this, the new Financial Stability Board (FSB) was established. As a result of this, in June 2009 the European Council (EC) established the European Systemic Risk Board (ESRB), which will monitor and assess potential threats to financial stability.
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On 26-27 June, the FSB held its first inaugural meeting in Basel, since the re-establishment as the FSB. The FSB announced signs of improvements in the global macroeconomic outlook and in certain financial markets, in particular funding markets but it is further emphasised that, in order to support sustained recover, bank lending needs to be strengthened.
CHAPTER 9: BIBLIOGRAPHY
Books: Adelson, Mark (2004): “Credit Default Swap (CDS) Primer." New York: Nomura, Securities International, Inc. Anson, Mark J. P., Fabozzi, Frank J., Choudhry, Moorad (2004): “Credit Derivatives: Instruments, Applications, and Pricing”, Hoboken, NJ, USA: John Wiley & Sons, Incorporated Arvind K. Jain (994): ”International Financial Markets and Institutions”, Kolb Publishing Company. Banks, Erik (2004): “Credit Risk of Complex Derivatives”, Palgrave Macmillan Bodie, Zivi, Kane, Alex, and Marcus, Alan J. (1999): “Investments”, 4th ed., New York: Irwin/ McGraw-Hill. Bomfim, Antulio N. (2005): ”Understanding Credit Derivatives and Related Instruments (1. edition)”. California, USA: Elsevier Inc. Coyle, Brian, 2002: Corporate bonds and commercial paper, Canterbury: Financial World Crouhy, Michel (2001): “Risk Management”, Blacklick, OH, USA: McGraw-Hill Companies Deacon, John (2004): “Global Securitisation and CDOs.” Hoboken, NJ, USA: John Wiley & Sons, Incorporated. Diamond and Dybvig (1983): “Bank Runs, Deposit Insurance, and Liquidity”, Federal Reserve Bank of Minneapolis Quarterly Review Vol. 24, No. 1, Winter 2000, pp. 14–23 Einzig, Paul (1962): “The History of Foreign Exchange”, Macmillan and Co. Ltd, New York St. Martin`s Press Freixas, Xavier, Martin, Antoine & Skeie, David (2009): “Bank Liquidity, Interbank Markets, and Monetary Policy”, Federal Reserve Bank of New York, Staff Report no. 371, May 2009 Staff Reports
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Grabbe, J. Orling (1996): “International Financial Markets”, Third Edition, Prentice Hall, Englewood Cliffs, New Jersey Gabriele Galati and Alexandra Heath (2007): “What drives the growth in FX activity? Interpreting the 2007 triennial survey”,BIS Quaterly Review, December 2007 Gallati, Reto (2003): “Risk Management and Capital Adequacy.” Blacklick, OH, USA: McGraw- Hill Companies. Hanajiri, T (1999): “Three Japan premiums in autumn 1997 and autumn 1998 – Why did premiums differ between markets”, Bank of Japan Financial Markets Department Working Paper Series no 99-E-1. Hefferman, Shelagh (2005): “Modern Banking”, John Wiley & Sons, Ltd. Hilley, John L, Beidleman, Carl R. & Greenleaf, James A. (1979): “Does Covered Interest Arbitrage Dominate in Foreign Exchange Markets?”,Columbia Journal of World Business; Winter 79, Vol. 14 Issue 4, p. 99-107, 9p, 3 charts. Horcher, Karen A. (2005): “Essentials of Financial Risk Management.” John Wiley & Sons, Incorporated Keynes, John Maynard (1924): “A Tract on Monetary Reform”, Volume IV, MacMillan St. Matin’s Press Levinson, Marc (2005): "Guide to Financial Markets", Profile Books Limited, Pages: 256, ISBN: 9781861979568 9781847650221 Lloyd B. Thomas (1997): Money, Banking, and Financial Markets, International Edition, Kansas State University, The McGraw-Hill Companies, Inc. Madura, Jeff (2000): Financial Markets and Institutions, Fifth Edition, Florida Atlantic University, South-Western College Publishing McGuire, P., von Peter, G. (2009): “The US Dollar Shortage in Global Banking”. BIS Quarterly Review (March), 47-63. McGuire, P., von Peter, G.(2008): “International Banking Activity amidst the Turmoil”. BIS Quarterly Review (June), 31-43. Moosa, Imad A. (2003): “International Financial Operations : Arbitrage, Hedging, Speculation, Financing and Investment”, Gordonsville, VA, USA: Palgrave Macmilla. Reverre, Stephane (2001): “Complete Arbitrage Deskbook”, Blacklick, OH, USA: McGraw-Hill Companies. Stigum, M and A Crescenzi (2007): Stigum’s money market, fourth edition, McGraw Hill.
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Van Greuning, Hennie (2003): “Analyzing and Managing Banking Risk : A Framework for Assessing Corporate Governance and Financial Risk (2nd Edition)”. Washington, DC, USA: World Bank Publications.
Articles: Adler, M. and Dumas, R. (1976): "Portfolio Choice and the Demand for Forward Exchange." American Economic Review (Mav 1976) pp. 332-339 Adrian T. and Shin H. S. (2008): "Liquidity and leverage". Journal of Financial Intermediation, doi:10.1016/j.jfi.2008.12.002 Agmon, T. and Bronfeld, S. (1975): “The international mobility of short-term arbitrage capital.” Journal of Business Finance and Accounting, vol. 2, pp. 269-78 Akerlof, G. A. (1970): “The Market for 'Lemons': Quality Uncertainty and the Market Mechanism”, Quarterly Journal of Economics, 84(3): 488-500 Aliber, Robert Z. (1973):”The Interest Rate Theorem: A Reinterpretation”. J.P.E. 81, no. 6, (November/December), pp. 1451-59 Allen, F. and Carletti, E. (2008): "The Role of Liquidity in Financial Crises", Jackson Hole Symposium on Maintaining Stability in a Changing Financial System, August 21-23 Allen, Franklin, Carletti, Elena and Douglas Gale (2008): “Interbank Market Liquidity and Central Bank Intervention”, Prepared for the Carnegie-Rochester Series on Public Policy Conference in November 2008 Andersen, Sparre, Kristian and Matzen, Anders (1998): “The use of Ratings in the European Capital Markets”, Danmarks Nationalbank, Monetary Review, 3rd Quarter. Ashcraft, Adam B. and Schuermann, Til (2008): “Understanding the Securitisation of subprime Mortgage Credit”, Federal Reserve Bank of New York Staff Report No.318 Atkins FJ (1993): “The dynamics of adjustment in deviations from covered interest parity in the Euromarket: Evidence from matched daily data.” Applied Financial Economics 3:183-187 Atkins FJ (1991): “Covered interest parity between Canada and the United States: Another look using modern time series methods.” Empirical Economics 16:325-334 Baba, N. (2009): “Dynamic Spillover of Money Market Turmoil from FX Swap to Cross- Currency Swap Markets: Evidence from the 2007-2008 Turmoil”, Journal of Fixed Income 18 (4), 24- 38. Baba, N., McCauley, R. N. and Ramaswamy, S. (2009): “US Dollar Money Market Funds and Non-US Banks”. BIS Quarterly Review (March), 65-81.
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Baba, N. and Packer, F. (2009a): “Interpreting Deviations from Covered Interest Parity During the Financial Market Turmoil of 2007-08”. Journal of Banking and Finance, forthcoming. Baba, N. and Packer, F. (2009b): “From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers”, BIS Working Papers No.285, Monetary and Economic Department. Baba, N., Packer, F. and Nagano, T. (2008): “The spillover of money market turbulence to FX swap and cross-currency swap markets”, BIS Quarterly Review, March 2008, 73-86. Baglioni (2009): “Liquidity Crunch In The Interbank Market: Is It Credit Or Liquidity Risk, Or Both?" July 2009, Catholic University Milan, working papers series 26 Baglioni A. - Monticini A. (2008 a): "The intraday price of money: evidence from the e-MID interbank market", Journal of Money, Credit and Banking, 40(7), 1533-1540. Baglioni A. - Monticini A. (2008 b): "The intraday interest rate under a liquidity crisis: the case of August 2007", Mimeo. Balke, N and Wohar, M. (1998): “Nonlinear dynamics and covered interest rate parity”, Empirical Economics, 23, 535--59. Beber, Alessandro, Brandt, Michael W. and Kavajecz, Kenneth A. (2006): “Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market.”, NBER Working Paper (June 2006). Bhattacharya, S. and Fulghieri, P. (1994): "Uncertain Liquidity and Interbank Contracting", Economics Letters 44, 287-294. Bhattacharya, S. and Gale, D. (1987): “Preference Shocks, Liquidity, and Central Bank Policy in”, W. Barnett and K. Singleton (eds.) New Approaches to Monetary Economics, Cambridge University Press, Cambridge. Blaise Gadanecz, Jacob Gyntelberg and Patrick McGuire (2009): “Highlights of international banking and financial market activity”, BIS Quarterly Review March 2009 Borio, C and Nelson, W (2008): “Monetary operations and the financial turmoil”, BIS Quarterly Review, March 2008, pp 31–46 Branson, William H. (1969):“The minimum Covered Interest Differential Needed for International Arbitrage Activity”, J.P.E 77, No.6 (November/December) Brunnermeier, M. (2009): “Deciphering the 2007-08 Liquidity and Credit Crunch”, Journal of Economic Perspectives, forthcoming
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Brunnermeier, Markus K. and Pedersen, Lasse Heje (2008):“Market Liquidity and Funding Liquidity”, RFS Advance Access published December 10 Chatterji, Aaron K. and Toffel, Michael W. (2009): “How Firms Respond to Being Rated”, Working Paper, Harward Business School Cantor, R., and F. Packer (1997): “Differences of Opinion in the Credit Rating Industry.”, Journal of Banking and Finance 21 (10), pp. 1395-1417. Cecchetti, Stephen G. (2008): “Monetary Policy and the Financial Crisis of 2007-2008.” mimeo, Brandeis International Business School (March 13) Clinton, K. (1988): “Transactions costs and covered interest arbitrage: theory and evidence.” Journal of Political Economy, 96, 358--70 Cook, Timothy Q. and Laroche, Robert K. (1993): “Instruments of the Money Market“, 7th Edition, Federal Bank of New York. Council of the European Union (2009): “Presidency Conclusions”, Brussels, 10 July 2009 Crockett, Andrew (2000): “Marrying the micro- and macro-prudential dimensions of financial stability” General Manager, Bank for International Settlements Chairman, Financial Stability Forum, Basel, Switzerland, 21 September 2000 David, Aikman (2008): “Comments on: ‘Financial (in)stability, supervision and liquidity injections: a dynamic general equilibrium approach”, Bank of England 3 July 2008 CCBS/WGEM Workshop: Financial Sector in Macro-Forecasting Dudley, William C (2009): “The Federal Reserve's liquidity facilities” BIS Review 48/2009, William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Vanderbilt University Conference on Financial Markets and Financial Policy Honoring Dewey Daane, Nashville, Tennessee, 18 April 2009 Duffie, Darrell and Singleton, Kenneth, J. (1999): “Modeling Term Structures of Defaultable Bonds”, The Review of Financial Studies, Vol. 12, No. 4 (1999), pp. 687-720 Eisenschmidt and Tapking (2009): “Liquidity risk premia in unsecured Interbank money markets” Working Paper Series No. 125, March 2009, European Central Bank. Farooq Akram (a), Dagfinn Rime (a) and Lucio Sarno (a,b) (2006): “Arbitrage in the Foreign Exchange Market: Turning on the Microscope” a: Norges Bank, b: University of Warwick and CEPR, February 2006 Financial Times (2008): “Money market on strike”, 9 November 2008 http://blogs.ft.com/economistsforum/2008/11/money-market-on-strike/
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Flannery M. (1996): “Financial crises, payment system problems, and discount window lending”, Journal of Money, Credit and Banking, 28(4), 804-824. Frenkel, Jakob A. (1973): “Elasticties and the Interest Rate Parity Theory”, J.P.E 81, No.3 (May/June), pp. 741-47 Frenkel, J. and Levich, R. (1975): “Covered interest arbitrage: unexploited profits?”, Journal of Political Economy, 83, 325--38 FSA (2009): “Re-establishment of the FSF as the Financial Stability Board”, Prepared remarks by Mario Draghi Chairman of the Financial Stability Forum, At conclusion of London Summit, 2 April 2009 FSB (2009):“FSF Principles for Cross-border Cooperation on Crisis Management”, 2 April 2009. Gadanecz, B (2004): “The syndicated loan market: structure, development and implications”, BIS Quarterly Review, December, pp 75–89 Gallanis, Mike (2009):”Market Turmoil: The Treasurer´s Point of View”, Financial Executive, vol 25, p.61-62 Greenspan, Alan (2009): “Greenspan’s Libor Barometer Shows Markets Stay Frozen (Update3)”, by Gavin Finch and Liz Capo McCormic, Bloomberg Gyntelberg Jacob and Philip Wooldridge (2008):“Interbank rate fixings during the recent turmoil”, BIS Quarterly Review, March 2008 House of Commons (2009): “Banking Crisis: regulation and supervision”, Fourteenth Report of Session 2008–09, House of Commons Treasury Committee, 31 July 2009, London Hieder et al (2009): “Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk”, April 1, 2009, European Banking Center Discussion Paper No. 2009-11S Heider, Florian , Hoerova, Marie and Holthausen, Cornelia (2009):“Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk”, 1 April 2009, European Banking Center Discussion Paper No. 2009-11S Hui, Cho-Hoi, Genberg, Hans and Chung Tsz-Kin (2009): “Funding Liquidity Risk And Deviations From Interest-Rate Parity During The Financial Crisis Of 2007-2009.” Working Paper 13/2009, 30 July 2009, Hong Kong Monetary Authority Hördahl, Peter and King, Michael R (2008): “Developments in repo markets during the financial turmoil”, BIS Quarterly Review, December 2008.
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João F. Cocco, Francisco J. Gomes, Nuno C. Martins (2009):“Lending relationships in the interbank market” J. Finan. Intermediation Interbank markets play a central role in distributing liquidity across the financial system (Cocco et al. (2009):46) Juhl, Ted, Miles, William and Weidenmier, Marc D. (2004): “Covered Interest Arbitrage: Then versus Now”, Economica (2006) 73, 341—352, The London School of Economics and Political Science 2006 Levich, R. M. (1985): “Empirical Studies of Exchange Rates: Price Behaviour, Rate Determination and Market Efficiency”, In (R. W. Jones and P. B. Kenen, eds.), Handbook of International Economics, vol. 2. Amsterdam: North-Holland. Longstaff, Francis A., Mithal, Sanjay, and Neis, Eric (2005a): "Corporate yield spreads: Default risk or liquidity? New evidence from the credit-default swap market", Journal of Finance 55, 2213-2253 Longstaff, Francis A. (2005b): “Asset Pricing in Markets with Illiquid Assets.” Working Paper (June 2005b) Lorenzo, Bini Smaghi (2009): “Going forward – regulation and supervision after the financial turmoil”, Member of the Executive Board of the European Central Bank, at the 4th International Conference of Financial Regulation and Supervision “After the Big Bang: Reshaping Central Banking, Regulation and Supervision”, Bocconi University, Milan, 19 June 2009 Officer, Lawrence H., and Willet, Thomas D. (1970):“The Covered-Arbitrage Schedule: A Critical Survey of Recent Developments.” J. Money, Credit and Banking 2, no.2 (May), 247- 257 McCauley, R N (2001):“Benchmark tipping in the money and bond markets”, BIS Quarterly Review, March, pp 39–45. McAndrews, James, Sarkar, Asani and Wang, Zhenyu (2008):"The Effect of the Term Auction Facility on the London Inter-Bank Offered Rate", Federal Reserve Bank of New York Staff Report 335. Mehlbye, Palle Duvier and Topp, Jacob (1996):”Udviklingen på pengemarkedet”, Pengepolitisk Kontor, Danmarks Nationalbank Melvin, M., Taylor, M. P. (2009):“The Crisis in the Foreign Exchange Market”. Journal of International Money and Finance, forthcoming.
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Michaud, F-L and C Upper (2008): “What drives interbank rates? Evidence from the Libor panel”, BIS Quarterly Review, March, pp 47–58. Michael, Kempa (2008): “Liquidity crisis in the interbank market”, 3rd June 2008, Swedish School of Economics and Business Administration; University of Helsinki Paul Tucker (2009):“Financial Stability, Bank of England” Paul Tucker Deputy Governor, at the British Bankers’ Association Annual International Banking Conference: Restoring Confidence – Moving Forward, London 30 June 2009 Pippenger J (1978):"Interest Arbitrage between Canada and the United States: A New Perspective", Canadian Journal of Economics (May 1978): 183-193. Prachowny, Martin F. (1970):”A Note on Interest Rate Parity and the Supply of Arbitrage Funds”, J.P.E 78, No.3 (May/June), pp. 540-50. Reuter (2008): “Darling details Bradford & Bingley bailout”,Monday, 29 September 2008 Schwarz K. (2009):"Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads", Working Paper, Columbia University Graduate School of Business. Shadow Financial Regulatory Committees of Asia, Australia-New Zealand, Europe, Japan, Latin America, and the United States (2007):“Lessons from Recent Financial Turmoil”, Joint Statement Copenhagen (Denmark), September 10 Sohmen, E. (1961): “Flexible Exchange Rates: Theory and Controversy”. Chicago: University of Chicago Press. Stein, Jerome L. (1962): “The Nature and Efficiency of the Foreign Exchange Market”, Essays in International Finance, no.40. Princeton, N.J.: Princeton Uni. Press. Stoll, H.R. (1972):"Causes of Deviation from Interest Rate Parity", J. Money, Credit, Banking, Feb. 1972, 4, 113-17 Tapking, J. and Weller, B. (2008):”Open Market Operations, Central Bank Collateral and the 2007/2008 Liquidity Turmoil”, Mimeo, European Central Bank Taylor, J. (2009): “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”,.NBER Working Paper No. 14631 Taylor, John B. and Williams, John C. (2008a): “A Black Swan in the Money Market”, Federal Reserve Bank of San Francisco, 1 April 2008, Working Paper 2008-04 Taylor, John B. and Williams, John C. (2008b): “Further Results on a Black Swan in the Money Market”, Federal Reserve Bank of San Francisco, May 23, 2008
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Taylor, M. P. (1987): “Covered interest parity: a high-frequency, high-quality data study”. Economica 54, 429--38 Taylor, M. P. (1989): "Covered Interest Arbitrage and Market Turbulence", Economic Journal 99: 376-391 Taylor, John B. & Williams, John C. (2008): “A Black Swan in the Money Market” Stanford University & Federal Reserve Bank of San Francisco, April 2008, Working Paper 2008-04 Thornton, Daniel L. (2009):“What the Libor-OIS Spread Says”, Daniel L. Thornton, Vice President and Economic Adviser, Federal Reserve Bank of St. Louis, short essays and reports on the economic issues of the day, 2009, Number 24 Wooldridge, P (2001):“The emergence of new benchmark yield curves”, BIS Quarterly Review, December, pp 48–57. Wu, Tao (2008): “On the Effectiveness of the Federal Reserve’s New Liquidity Facilities”, Research Department Working Paper 0808 Federal Reserve Bank of Dallas Publications:
Press Releases: BNP Paribas (2007-PR): “BNP Paribas Investment Partners temporaly suspends the calculation of the Net Asset Value of the following funds : Parvest Dynamic ABS, BNP Paribas ABS EURIBOR and BNP Paribas ABS EONIA” 9 August 2007 BoC (2007a): “Bank of Canada Temporarily Expands List of Collateral Eligible for SPRA Transactions”, 15 August 2007 BoC (2007b): “The Bank of Canada’s Target for the Overnight Interest Rate Policy Implementation Framework” BoC (2007c): “Bank of Canada welcomes initiatives to support the functioning of financial markets in Canada”, 16 August 2007 BoC (2007-PRc): “Bank of Canada keeps target for the overnight rate at 4 1/2 per cent”, 5 September 2007, Bank of Canada BoC (2007-PRd): “Bank of Canada lowers overnight rate target by 1/4 percentage point to 4 1/4 per cent”, 4 December 2007, Bank of Canada BoC (2008-PRlol):“Central Banks Announce Coordinated Interest Rate Reductions”, 8 October 2008 BoE (2007): “Financial Stability Report”, October 2007, Issue No. 22 BoE (2007aa): “Bank of England Market Notice: US Dollar Repo Operations”,Bank of England BoE (2008ab): “Special Liquidity Scheme: Information”,21 April 2008 BoE (2008ac): “Special Liquidity Scheme: Market Notice”, 21 April 2008 BoE (2008-PRlol): “Bank of England Reduces Bank Rate by 0.5 Percentage Points to 4.5%”, Bank of England, 8 October 2008.
Side 106 af 112 Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
BoJ (2007-PRb): “Announcement of the Monetary Policy Meeting Decisions”, 19 September 2007, Bank of Japan. BoJ (2008-PRlol): “On the Policy Actions by Major Central Banks” 8 October 2008 CGFS (2008): “Central bank operations in response to the financial turmoil”, CGFS Papers No 31., July 2008, Committee on the Global Financial System (CGFS), Bank of International Settlement. CGFS (2008-No.31): “Central bank operations in response to the financial turmoil”, CGFS Papers No 31, July 2008, Committee on the Global Financial System, Bank for International Settlements. Danmarks Nationalbank (2007-3): “Monetary Review 3rd Quarter”, 14 September, 2007. ECB (2007-PRa ): “Monetary policy decisions”, 6 September 2007, European Central Bank ECB (2007-PRoo): “Monetary policy and the money market: key principles and recent experience” Speech by Jürgen Stark, Member of the Executive Board of the ECB delivered at Bayerischer Bankenverband, Munich, 15 November 2007 ECB (2008-PR): ”Monetary policy decisions”, 8 October 2008. ECB (2008-PR15 Oct): “Measures to further expand the collateral framework and enhance the provision of liquidity”, 15 October 2008 ECB (2008-PR18 Dec):“Tender procedures and the standing facilities corridor as of 21 January 2009”, 18 December 2008 ECB (2008-PRe): “Tender Procedure for the Provision of US Dollars to Eurosystem Counterparties under the Term Auction Facility”, Press Release, 30 July 2008. ECB (2008-PRlol): ”Monetary policy decisions”, 8 October 2008 European Commission (2009): “Functional Definition of a Central Counterparty Clearing House (CCP)”, 28 July 2009. European Commission (2009PR): “2948th Council Meeting Economic and Financial Affairs”, 9 June 2009, press release 10737/09 FDIC (2008):“JPMorgan Chase Acquires Banking Operations of Washington Mutual”, 25 September 2008, Federal Deposit Insurance Corporation FEDBNY (2007k): “Statement Regarding Repurchase Agreements Covering Year-End”, Federal Reserve Bank of New York, November 26, 2007
Side 107 af 112 Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Federal Reserve Bank of New York (FRBNY) (2008): “Treasury Market Practices Group Endorses Several Measures to Address Widespread Settlement Fails”, Announcement, November 12, 2008. Federal Reserve System (2008lol): “Federal Reserve and other central banks announce reductions in policy interest rates”, 8 October 2008, Board of Federal Reserve System FED (2008-PRa): “Press Release”, October 28, 2008 FED (2008-PRb): “Press Release”, October 29, 2008 FED (2008- PRc): “Press Release”, July 30, 2008 FED (2008-PRf): “Press Release”, 16 September 2008 FED (2008-PRlok): “DISCOUNT AND ADVANCE RATES -- Requests by nine Reserve Banks to lower the primary credit rate; requests by three Reserve Banks to maintain the existing rate”, 15 December 2008 Federal Reserve System (2007-94th): “94th Annual Report”, Board of Governors of the Federal Reserve System Federal Reserve System (2007LL): “Federal Reserve Actions”, 12 December 2007, Board of Federal Reserve System Federal Reserve System (2007mn): “FOMC Statement”, September 18, 2007, Board of Federal Reserve System Federal Reserve System (2007mo): “FOMC statement and Board approval of discount rate requests of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco”, 31 October 2007, Board of Federal Reserve System Federal Reserve System (2007mp): “FOMC statement and Board approval of discount rate requests of the Federal Reserve Banks of New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, and St. Louis”, 11 December 2007, Board of Federal Reserve System Federal Reserve System (2007mz): “Federal Reserve and other central banks announce measures designed to address elevated pressures in short-term funding markets”, 12 December 2007, Board of Federal Reserve System Federal Reserve System (2008LL): “Press Release”, 16 March 2008, Board of Federal Reserve System Federal Reserve System (2008mq): “FOMC statement and Board approval of discount rate requests of the Federal Reserve Banks of Chicago and Minneapolis”, 22 January 2008, Board of Federal Reserve System
Side 108 af 112 Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
Federal Reserve System (2008mr): “FOMC statement and Board approval of discount rate requests of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco”, 30 January 2008, Board of Federal Reserve System Federal Reserve System (2008ms): “FOMC statement and Board approval of discount rate requests of the Federal Reserve Banks of New York, Cleveland, Atlanta, and San Francisco”, 30 April 2008, Board of Federal Reserve System Federal Reserve System (2008mt): “Federal Reserve and other central banks announce specific measures designed to address liquidity pressures in funding markets”, 1 March 2008, Board of Federal Reserve System Financial Market Stabilization Fund (SoFFin) (2009): “SoFFin holds 47.31 percent of Hypo Real Estate Holding AG (HRE)”, Frankfurt am Main, 7 May 2009 FSB (2009-PR): “Financial Stability Board holds inaugural meeting in Basel”, Financial Stability Board, Ref no: 28/2009, 27 June 2009 Government of Netherlands (2008): “Benelux comes to aid of Fortis”, 29 September 2008 Mishkin (2007-SP): “Financial Instability and Monetary Policy”, Speech, Governor Frederic S. Mishkin, At the Risk USA 2007 Conference, FED, New York, New York November 5, 2007 RBA (2007a): “Domestic Market Dealing Arrangements”, 6 September 2007, Reserve Bank of Australia RBA (2007-PRcc): “Statement by Glenn Stevens, Governor, Monetary Policy”, 8 August 2007, Reserve Bank of Australia RBA (2007-PRcd): “Statement by Glenn Stevens, Governor, Monetary Policy”, 7 November 2007, Reserve Bank of Australia RBA (2008-PRcc): “Statement by Glenn Stevens, Governor, Monetary Policy”, 5 February 2008, Reserve Bank of Australia Riksbank (2007-PRa): “Repo rate raised by 0.25 percentage points to 4 per cent”, 30 October 2007 Riksbank (2007-PRb): “Repo rate raised by 0.25 percentage points to 4.25 per cent”, 13 February 2008. Riksbank (2008-PRlol): “Repo rate cut to 4.25 per cent”, 8 October 2008. SNB (2007aa): “SNB to expand its list of collateral eligible at the central bank”, 14 August 2007,
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SNB (2007-PRcc): “Monetary policy assessment of 13 December 2007”, Swiss National Bank, Zurich SNB (2007-PRcd): “Monetary policy assessment of 13 September 2007, SNB aiming to calm the money market”, Swiss National Bank, Zurich SNB (2008-PRcc): “Monetary policy assessment of 13 March 2008”, Swiss National Bank, Zurich SNB (2008-PRd): “Swiss National Bank to offer extended-term US dollar repo operations”, Press Release, Zurich 30 July 2008. SNB (2008-PRlol): “Joint statement by central banks”8 October 2008, Zürich
Publications Basel Komiteen (2000): “Sound Practices for Liquidity Risk Management in Banking Organisations”, BIS BBA (2009): “BBA LIBOR”, John Ewan, Director. BIS (1983): “The International Interbank Market- A Descriptive Study”, Monetary and Economic Department Basle, Economic Papers, No. 8, July 1983, p.1-44 BIS (1999a): “Market Liquidity: Research Findings and Selected Policy Implications.”Committee on the Global Financial System Publications No. 11 BIS (1999b): “Principles for the Management of Credit Risk” Consultative paper issued by the Basel Committee on Banking Supervision Issued for comment by 30 November 1999 Basel BIS (2003): “Basel II: The New Basel Capital Accord”, Third Consultative Paper (ok) BIS (2007n): “Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in 2007”, December. BIS (2007t): “International money market disruptions, central bank reactions and lessons learnt” Introductory remarks by Mr. Thomas Jordan, Member of the Governing Board of the Swiss National Bank, at the end-of-year media news conference, Zurich, 13 December 2007. BIS (2008): "Ratings in structured finance: what went wrong and what can be done to address shortcomings?” CGFS Papers No 32. BIS (2008d): “Overview: global financial crisis spurs unprecedented policy actions”, BIS Quarterly Review, December BIS-No.31 (2008):”Central Bank Operations in response to the financial Turmoil”, Committee on the Global Financial System (CGFS) Papers No.31, July. BIS (2009abc): “79th Annual Report”,1 April 2008– 31 March 2009, Basel, 29 June 2009
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BIS Quarterly Review (2009-March): “International banking and financial market developments”, March 2009 BoE (2008-Annex): “Financial Stability Review”, Issue 24, Bank of England, Annex Danmarks Nationalbank (2003): “Finansiel styring I Danmarks Nationalbank”, 1.udgave, 4.opslag. Danmarks Nationalbank (2004): “Bodil Nyboe Andersens tale på Finansrådets årsmøde” Danmarks Nationalbank (2008-1): “1. Quarter Monetary Review” ECB (2007): Financial Stability Review, December, European Central Bank ECB (2008): “Financial Stability Review” (June), European Central Bank. ECB (2008t): “The Implementation of Monetary policy in the Euro Area”, General Documentation on Eurosystem Monetary Policy Instruments and Procedure, November 2008. ECB ( 2009): “Financial Stability Review” (June). ECB (2009mm): “Euro Money Market Study 2008”, February 2009, European Central Bank. Fed (2009-MR): “Credit and Liquidity Programs and the Balance Sheet” Federal Reserve System Monthly Report, August 2009 Federal Reserve Bank of New York (2007): “Treasury and Federal Reserve exchange operations: July-September 2007”, November. FEDBNY (2001): “SOMA Securities Lending Program Terms and Conditions (Revised)”, Effective October 18, 2001, Federal Reserve Bank of New York Fitch Rating (2007): “Inside the Ratings: What Credit Ratings Means”, August Fitch Ratings (2009a): “Sovereigns: European government borrowing”, International Special Report, 26 January. Fitch Ratings (2009b): “Definitions of Ratings and Other Scales”, March IMF (2008c): “Market and Funding Illiquidity: When Private Risk Becomes Public”, Global Financial Stability Report (GFSR), April 2008, p.86-117 IMF (2008-Apr): “Global Financial Stability Report, Containing Systemic Risk and Restoring Financial Soundness”, World Economic and Financial Surveys, International Monetary Fund Washington DC IMF (2008): “Global Financial Stability Report, Containing Systemic Risks and Restoring Financial Soundness”, World Economic and Financial Surveys, April2008 IMF (2009): “Global Financial Stability Report Responding to the Financial Crisis and Measuring Systemic Risks”, World Economic and Financial Surveys, April 2009, Washington DC.
Side 111 af 112 Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy matters and risk management
IMF (2009-Update): “Global Financial Stability Report –Market Update”, Monetary and Capital Market Department, July 2009. J.P. Morgan: CreditMetrics – “Technical Document”, 1997, J.P. Morgan OECD (2007):” Glossary of Statistically Terms” Organisation for Economic Co-operation and Development. SNB (2009): “Financial Stability Report”, Swiss National Bank SNB (2009-Appendix): “Results of the US dollar auctions”, Swiss National Bank Standard & Poor (2009): “Standard & Poor's Ratings Definitions” April 30. World Bank (2008): “Global Development Finance 2008, the Role of International Banking”, I: Review, Analysis, and Outlook.
Websites: Standard & Poor's: http://www.standardandpoors.com Moody’s Investors Service: http://www.moodys.com Fitch: http://www.fitch.com UK Government: http://www.direct.gov.uk Die Bundesregierung: http://www.bundesregierung.de The U.S. Government's Official Web Portal: http://www.usa.gov British Bankers Association: http://www.bbalibor.com/bba/jsp/polopoly.jsp?d=1663, Date: 27 July 2009 European Baking Federation: http://www.fbe.be/Content/Default.asp, http://ebf.irisb2b.com/Contents/Contents.asp, Date: 27 July 2009. International Swaps and Derivatives Association: http://www.isda.org/ Eurepo: http://www.eurepo.org/ bbalibor™: http://www.bbalibor.com/bba/jsp/polopoly.jsp?d=1621
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