Precautionary hoarding of liquidity and inter bank markets evidence from the sub prime crisis
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Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis. Ouarda Merrouche Bank of England (with Viral V. Acharya, London Business School) PRELIMINARY-COMMENTS WELCOME 5 September 2008. FS252347. Importance of money markets.

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Precautionary hoarding of liquidity and inter bank markets evidence from the sub prime crisis

Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis

Ouarda Merrouche

Bank of England

(with Viral V. Acharya, London Business School)

PRELIMINARY-COMMENTS WELCOME

5 September 2008

FS252347


Importance of money markets
Importance of money markets Evidence from the Sub-prime Crisis

  • Money markets lubricate credit flows in the economy

    • Well-functioning inter-bank markets ensure that liquidity travels to the place where it is needed the most

    • Central Banks, through their monetary policy operations (reserve requirements, averaging, and corridors) can target interest rates

  • Conversely, a freeze in the money markets can

    • Impair or stagnate lending to the real sector

    • Force Central Banks to undertake massive liquidity operations, possibly undertaking credit risk in the process

  • This paper

    • View of money markets from the lens of “precautionary liquidity”


Liquidity hoarding and the freeze
Liquidity hoarding and the freeze Evidence from the Sub-prime Crisis

  • FT 12 August 2007: “Scramble for cash reflects fears for system”

  • FT 26 March 2008: “Hoarding by banks stokes fear over crisis”

  • FT 19 May 2008: “Loans to banks limited despite market thawing”

    “ It is unclear to what extent hoarding of liquidity reflects a genuine need to stem rising losses, and to what extent it reflects an extremely precautionary behavior driven by high uncertainty…”

    – Marco Annunziata, chief economist at UniCredit bank


Questions
Questions Evidence from the Sub-prime Crisis

  • What is the impact of precautionary liquidity hoardings of banks on inter-bank markets?

    • The issue of reverse causation

  • Can one establish that liquidity hoardings are indeed precautionary in nature?

  • Does the variability in inter-bank rates induced by liquidity hoardings matter?

    • What are the policy implications for Central Banks?


Setting
Setting Evidence from the Sub-prime Crisis

  • Sterling money markets

    • Overnight and 3-month secured and unsecured

    • Rates as well as volumes

  • Reserve balances of large, settlement banks

    • A good measure of daily liquidity

    • Can add collateral to get a measure of total liquidity

  • Payments and settlements activity

    • CHAPS

  • Bank-level distress and funding liquidity stress

  • Bank-level household and corporate lending rates, volumes


Tiered structure of the markets
Tiered Structure of the Markets Evidence from the Sub-prime Crisis

  • 400 banks active in the UK

  • 15 direct participants in the large-value payment system (CHAPS) i.e. settlement banks

  • Tiered structure reflected in money market activities

    • Top 4 first-tier clearers intermediate liquidity

    • Horizontal flow at first-tier + Vertical flow between second-tier and first-tier

    • Limited horizontal flow of liquidity at the second tier


Monetary policy framework
Monetary Policy Framework Evidence from the Sub-prime Crisis

  • No requirement to hold reserves (voluntary) i.e. choice of reserves targets (limited by a ceiling)

  • 1 Month maintenance period

  • Remuneration at policy rate

  • Zero percent on average reserves above 101% of target. Equivalent penalty for average reserves below 99%

  • Liquidity provided by weekly OMO (Thursdays)


Adjustments during the crisis
Adjustments during the Crisis Evidence from the Sub-prime Crisis

  • September 13th-18th 2007 OMOs: 25 % of reserves target additional liquidity injected in OMO

  • September 19th: 3 months actions against wider range of collateral

  • October 4th 2007: Widening of bands around target from 1% to 30 percent

  • April 21st 2008: Special Liquidity Scheme

  • May 8th 2008: Double reserves Target Ceiling


Results i
Results - I Evidence from the Sub-prime Crisis

  • Regime shift in aggregate bank liquidity levels

    • Reserve targets have risen (August ’07, March ’08)

    • Also levels of daily and total liquidity

  • Relationship between aggregate liquidity and rates has ALSO undergone a structural shift

    • Pre-crisis: Rise in liquidity caused rates to be lower

      • Traditional money-market arbitrage argument

    • Post-crisis: Rise in liquidity caused rates to rise

      • Private benefit of liquidity above the policy rate

    • Effect on secured as well as unsecured rates

      • Unlikely due to counterparty risk on transactions


Theory of financial constraints
Theory of financial constraints Evidence from the Sub-prime Crisis

  • Normal times: unconstrained banks

    • Reserves set primarily to meet regulatory requirements and to some extent settlement uncertainty

    • Private benefit of liquidity relatively low

    • If reserves increase, banks “release” them pushing rates down towards the policy rate

  • Crisis times: banks are funding-constrained

    • Banks build up reserves for precautionary reasons

      • Other than settlement uncertainty or more responsively so

    • Private benefit of liquidity relatively high

    • If reserves increase, banks “release” them ONLY IF return on liquidity exceeds the private benefit


Revised arbitrage condition
Revised arbitrage condition Evidence from the Sub-prime Crisis

  • Inter-bank rate = Policy rate + Liquidity premium

  • Implications

    • Should apply to secured as well as unsecured as liquidity premium is about opportunity costs, not counterparty risk

    • Liquidity premium induces an additional source of uncertainty in spread of inter-bank to policy rate

    • Unlikely due to differences in collateral

    • Contagion:

      • Likely to affect ALL borrowing banks

      • Liquidity hoarding entails withdrawals elsewhere (other banks, households, corporations)


Results ii
Results - II Evidence from the Sub-prime Crisis

  • Bank-level liquidity hoardings appear indeed to be precautionary in nature

    • Larger for banks that had

      • Greater losses

      • Larger equity price decline

      • Greater reliance on wholesale funding

  • There is evidence of contagion

    • Bank-level borrowing rates increase with liquidity hoardings of other banks during the crisis

    • Bank-level lending rates rise in response to individual inter-bank rate of borrowing


Liquidity measures
Liquidity measures Evidence from the Sub-prime Crisis

  • Total Liquidity = Overnight Liquidity + Intraday Collateral

  • Overnight Liquidity = Reserves Accounts Balance at 5 am

  • Intraday Collateral = Maximum Collateral posted to obtain intraday credit from central bank

  • NOTE: In bank-level regressions, we employ these measures, scaled by subtracting mean and dividing by standard deviation so as to focus on abnormal variations


Total liquidity
Total liquidity Evidence from the Sub-prime Crisis


Settlement bank reserves
Settlement bank Reserves Evidence from the Sub-prime Crisis

September 11th 2007

March 13th 2008


Omo bids
OMO Bids Evidence from the Sub-prime Crisis


Policy rate
Policy Rate Evidence from the Sub-prime Crisis


Bai perron tests
Bai-Perron tests Evidence from the Sub-prime Crisis

Total Liquidity

Overnight Liquidity


Regime shift in bank reserves
Regime shift in bank reserves Evidence from the Sub-prime Crisis

  • FT 9 April 2008: “UK banks seek higher borrowing facilities”

  • FT 10 April 2008: “UK banks seek more BoE borrowing”

    “UK banks asked to increase sharply the reserves they hold on deposit at the Bank this month to the highest ever level amid concerns that the instability of the banking system could suddenly leave them desperate for cash. They fear another bank crisis - akin to the collapse of US investment bank Bear Stearns - could see the market seize up.

    Banks have asked to keep total reserves of £23.54bn on deposit that they can borrow to meet short-term financing needs if they cannot borrow in the inter-bank market. This is up from the nearly £20bn they had on deposit until yesterday. This is money the banks keep on deposit at the Bank, earning interest, but that they can access when the cost of borrowing from other banks becomes too high.”


Money market rates
Money market rates Evidence from the Sub-prime Crisis

Overnight Secured Rate = Gilt Repo Rate

Overnight Unsecured Rate = SONIA Rate

3-Months Secured = Gilt Repo Rate

3-Months Unsecured = 3-Months Libor

3-Months Unsecured volume = CHAPS 3-months volume, extracted using Furfine (1998) algorithm


Money market rates and volumes
Money market rates and volumes Evidence from the Sub-prime Crisis

Difference Post August 9th – Pre August 9th


Spreads to policy rate
Spreads to policy rate Evidence from the Sub-prime Crisis


Liquidity and secured spread
Liquidity and secured spread Evidence from the Sub-prime Crisis


Liquidity and 3 month libor ois
Liquidity and 3-month LIBOR-OIS Evidence from the Sub-prime Crisis


Identification problem
Identification problem Evidence from the Sub-prime Crisis

  • Econometric problem

    • Liquidity responds to uncertainty and rate expectations

    • Rates may also rise due to uncertainty

    • Effect of liquidity on rates may thus be due to endogeneity or omitted variable bias, rather than causal

  • Solutions

    • Examine overnight GILT secured rates

    • Correct for correlated shocks through SURE

    • Apply instrumental variable approach to correct endogeneity biases

  • We adopt all three


Control variables
Control Variables Evidence from the Sub-prime Crisis

  • OMO days

  • Maintenance days fixed effects

  • Adjustments to Monetary Policy Framework: (1) widening of bands; (2) higher reserves ceiling + liquidity scheme

  • (Uncovered OMO on last week of June 2007)


Liquidity and rates
Liquidity and rates Evidence from the Sub-prime Crisis


Instrument
Instrument Evidence from the Sub-prime Crisis

  • Lagged level of aggregate payment and settlement activity (value, volume)

  • Rationale:

    • High settlement activity days are accompanied by higher liquidity reserves

      • Buffer against greater reserves uncertainty in future

    • If liquidity reserves are imperfectly adjusted on a day to day basis, there would be residual effect in liquidity reserves of past settlement activity

      • Ultimately, an empirical question

    • Settlement activity driven by calendar-day effects, and thus uncorrelated over time


Payment and settlement activity
Payment and settlement activity Evidence from the Sub-prime Crisis

CHAPS payment activity value and volume

Net of overnight inter-bank loans, in logarithm and in bank-level regressions, scaled by subtracting mean and dividing by standard deviation

High value for same volume = Larger transactions, greater risk

High volume for same value = Smaller transactions, lower risk


Chaps payment activity value
CHAPS payment activity: value Evidence from the Sub-prime Crisis


Chaps payment activity volume
CHAPS Payment activity: volume Evidence from the Sub-prime Crisis


Liquidity and rates second stage
Liquidity and rates (second-stage) Evidence from the Sub-prime Crisis


Economic significance
Economic significance Evidence from the Sub-prime Crisis

  • Liquidity effect

    • Pre-Crisis: a 10 per cent increase in overnight liquidity causes a 6.6 basis points decline in overnight secured spread

    • During Crisis: a 1.1 basis points rise in overnight secured spread

    • During Crisis: a 24 basis points rise in 3-M Libor-OIS spread


Liquidity and payments first stage
Liquidity and payments (first-stage) Evidence from the Sub-prime Crisis


Payments and calendar effects
Payments and calendar effects Evidence from the Sub-prime Crisis


Precautionary nature of liquidity
Precautionary nature of liquidity Evidence from the Sub-prime Crisis

  • Approach 1: Assess contribution to structural break in liquidity by Loss Ratio and Retail Ratio

  • Approach 2: Split sample of banks into two groups to allow heterogeneous reaction to aggregate fluctuations in payment activity

    • Higher and lower than median loss ratio to total assets

    • Higher and lower than median retail to inter-bank deposit ratio

    • Higher and lower than median bank equity price variation from 2006


Results i1
Results I Evidence from the Sub-prime Crisis


Result ii
Result II Evidence from the Sub-prime Crisis


Bank characteristics
Bank characteristics Evidence from the Sub-prime Crisis

  • Losses Disclosed relative to Total Assets

  • Source: Bloomberg

  • Period: January 2007-June 2008

  • Initial Retail over Inter-bank Deposits Ratio

  • Source: Interim reports as of June 2007

  • Period: Immediate Pre-Crisis Level


Economic significance1
Economic significance Evidence from the Sub-prime Crisis

  • Precautionary Hoarding

    • During Crisis: a 1 percent rise in value of payment activity is associated with a 0.26 per cent rise in settlement banks’ overnight liquidity buffer

    • Before Crisis: no reaction

    • Banks that disclosed a loss ratio of one standard deviation above the mean increased their overnight liquidity by an additional 25 per cent of a standard deviation


Data on real sector lending
Data on real-sector lending Evidence from the Sub-prime Crisis

  • Fixed and Floating Rate

    • New loans to Households and PNFC

    • Spread to policy rate

  • Growth rate of lending volume to Households and PNFC

  • Source: Bank of England Statistics Department MFSD data


Transmission i
Transmission - I Evidence from the Sub-prime Crisis


Transmission ii
Transmission - II Evidence from the Sub-prime Crisis


Economic significance2
Economic significance Evidence from the Sub-prime Crisis

  • Transmission

    • Rates

      • During Crisis: A 1 basis point increase in secured spread causes a 1.3 basis points increase in the retail floating rate

      • Before Crisis: no effect

      • All times: A 1 basis point increase in secured spread causes a 1.4 basis points increase in corporate loans fixed rate

    • Volumes

      • During Crisis: a 1 basis point rise in secured spread causes a 0.146 % decline in growth rate corporate lending

      • Before Crisis: no effect


Conclusion
Conclusion Evidence from the Sub-prime Crisis

  • Evidence of precautionary liquidity hoardings during the crisis, with effect on inter-bank rates (secured, unsecured)

    • The standard “money-market arbitrage” requires adjustment

  • Why does the effect matter?

    • Contagion from liquidity-strapped banks to others

    • Transmission through rates to households, corporations

  • Policy implications

    • There seems at least an ex-post rationale for liquidity injections

    • Can serve to eliminate liquidity-induced volatility and contagion

  • Future work

    • Examine money-markets bilaterally (market power, cornering)

    • Study term-structure effects (substitution), if any


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