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The interbank market after August 2007: The interbank market after August 2007: what has changed and why? what has changed and why? Cristina Picillo Banca dItalia- Market and Payment Systems Oversight Department ABM-BaF09 February 11 th

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The interbank market after August 2007: The interbank market after August 2007: what has changed and why? what has changed and why?

Cristina Picillo

Banca d’Italia- Market and Payment Systems Oversight Department

ABM-BaF09 – February 11th, 2009

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1 Motivation of this paper and existing literature 2 The data 3 Regression 4 Estimation results 5 Conclusions

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Outline

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1 Motivation of this paper and existing literature 2 The data 3 Regression 4 Estimation results 5 Conclusions

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Outline

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Spreads between uncollateralized and collateralized rates

(basis points; daily data)

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Motivation: strains in interbank markets

30 60 90 120 150 180 210 240 270 300 330 360 390 420

Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08

3-month US dollar spread (b.p.) 3-month euro spread (b.p.)

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Which role for:

  • Deterioration of measures of counterparty creditworthiness
  • Increase in perception of default risk
  • Generalized increase in lender’s risk aversion
  • Window-dressing/accounting practices
  • Reduction in market and/or funding liquidity
  • Lender’s characteristics

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Which are the determinants of the spreads?

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  • Taylor and Williams (2008): increased counterparty risk
  • Wu – McAndrews et al. (2008): increased counterparty

risk but also reactivity to central banks interventions

  • Michaud and Upper (2008): cointegrating relationship

between counterparty risk and spreads

  • Cassola et al. (forthcoming): asymmetric information

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The literature on spreads’ decomposition

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1 Motivation of this paper and existing literature 2 The data 3 Regression 4 Estimation results 5 Conclusions

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Outline

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Dependent variable

  • Sample period: January, 24th 2005 - December, 31st
  • 2008. Main focus: up to Lehman’s collapse
  • Individual daily transactions on e-MID
  • Dependent variable in long-term spread regression: e-

MID individual rate minus Eurepo rate of the same maturity

  • Maturity:1 week, 2 weeks, 3 weeks, 1 month, 2 months,

3 months, …, 6 months,…, 12 months

  • Pooling of maturities: average transaction of 37 days

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The data

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Independent variables

  • Bank-specific variables:
  • ratings (Fitch, Moody’s, S&P’s; daily)
  • balance sheet data (Banca d’Italia’s supervisory

reports; quarterly)

  • Market-wide variables:
  • maturity dummies (“term structure” pattern)
  • window-dressing dummies (seasonal patterns)
  • bid/ask dummy
  • overall risk aversion measure (from the stock

market; Jackwerth 2000).

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The data

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e-MID spreads: empirical distribution

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The data

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e-MID spreads: empirical distribution

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The data

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Deterioration of counterparty creditworthiness?

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The data

Crisis Including Lehman Before crisis Crisis Excluding Lehman 143.8 143.8 251.6 251.6 max 6.2 6.3 5.6 5.6 min 15.8 16.7 12.9 13.9 st dev 15.7 15.9 14.7 15.0 mean Capital ratio (percentage points) 12.99 12.98 12.96 12.99 max 5.41 5.82 4.88 4.88 min 1.43 1.34 1.35 1.38 st dev 9.18 9.10 9.12 9.14 mean Bank size (ln of total assets in billions of euro) 12 12 12 12 max 3 3 3 3 min 2.1 2.1 1.8 1.9 st dev 6.9 7.0 7.0 6.9 mean Rating (Fitch long-term issuer default rating) Overall sample

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1 Motivation of this paper and existing literature 2 The data 3 Regression 4 Estimation results 5 Conclusions

The The interbank interbank market after market after August August 2007: 2007: what what has has changed changed and and why why? ?

Outline

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it t turm t t t turm it it it

D z z D x x c r ε β β β β + + + + + =

, 4 3 , 2 1

) (

The The interbank interbank market after market after August August 2007: 2007: what what has has changed changed and and why why? ?

The regression

,

Bank-specific variables Market-wide variables Structural break Spread Up to September 13th 2008 Including Lehman’s failure (up tp December 31st 2008)

,12,34,()itlehmtititturmtttturmtitrcDxxDzzDββββε=++++++

  • 2. Structural break
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1 Motivation of this paper and existing literature 2 The data 3 Regression 4 Estimation results 5 Conclusions

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Outline

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Estimation results

0.92 R2 15,179 20,553

  • No. obs

27.07** 3.05**

Risk aversion

  • 3.62**
  • 2.51**

Capital ratio seller

  • 23.63**
  • 0.45**

Capital ratio

  • 1.06**
  • 0.38**

Ln(total assets)

  • 3.44**
  • 1.76**

Bank has no rating (0-1) 0.42** 0.26** Rating

  • Coef. _i
  • Coef. _i

Bank-specific characteristics During turmoil excluding Lehman Before turmoil

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Use “jump” dummies for annual and quarterly effects.

  • E.g. for 1 week rate:
  • Annual dummy set to 1 between Dec 24&Dec31
  • Quarterly dummy set to 1 between March 24&31,

June23&30, …

  • E.g. for 1 month rate:
  • Annual dummy set to 1 between Dec1&Dec31
  • Quarterly dummy set to 1 between March 1&31,

June1&30, …

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Window-dressing effects

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Estimated window-dressing effects

  • 10

10 20 30 40 50 60 70 1 week 2 week 3 week 1 month 2 month 3 month maturities end-of-quarter, before turmoil end-of-quarter, during turmoil end-of-year, before turmoil end-of-year, during turmoil

(**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**) (**)

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Robustness checks

  • Replicating analysis on overnight spread
  • Changing the rating variable
  • Separate regressions for rated and not rated banks
  • Consolidated balance sheet data
  • Allowing interaction between bank-specific variables

and maturity dummies

  • Separate regression for bid/ask contracts
  • Individual regressions for each maturity
  • Omitting overall risk-aversion
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  • (i) Set rating to 3 (best rating) for all banks
  • (ii) Obtain fitted values
  • (iii) Take averages of fitted values over pre- and

turmoil periods

  • Set size to largest size (top decile) for all banks
  • (ii) Obtain fitted values
  • (iii) ………

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Simulating spreads

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Simulated long-term spreads (basis points)

(basis points)

9Aug07- 13Sep08 24Jan05– 8Aug07 44 7 worst rated, small, poorly capitalized banks (b) 38 5 poorly capitalized banks 40 6 small banks 40 6 banks with worst rating 27 3 best rated, large, highly capitalized banks (a) 34 5 highly capitalized banks 34 4 large banks 37 5 banks with no rating 34 4 banks with best rating for 32 4 net of window dressing/accounting effects 12 3 net of effect of risk aversion Estimated cost of funds 37 5 Average cost of funds

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Determinants of the spread

In order of importance:

(1) generalized increase in risk-aversion (70%) (2) heightened reactivity to borrowers’ characteristics (25%)

 Discount to larger banks much larger than before

(3) window-dressing accounting practices (remaining)

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1 Motivation of this paper and existing literature 2 The data 3 Regression 4 Estimation results 5 Conclusions

The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Outline

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Conclusions

  • Risk aversion is the main determinant of the

increase in the spreads

  • Banks have become more discerning in their

lending, a welcome change

  • Large increase in the discount obtained by

large borrowers suggests risk of moral hazard has considerably increased. Reason of concern for central banks.

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Thank you for your attention!

cristina.picillo@bancaditalia.it

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Estimation results

0.92 0.92 15,179 27.07**

  • 3.62**
  • 23.63**
  • 1.06**
  • 3.44**

0.42**

  • Coef. _i

excluding Lehman OLS 16,015 30.40** 6.37

  • 18.37**
  • 0.84**
  • 5.15**

0.74**

  • Coef. _i

including Lehman OLS 0.91 29.33**

  • 11.81**
  • 18.13**
  • 0.63**
  • 5.03**

0.72**

  • Coef. _i

including Lehman Random effects R2

  • No. obs

Risk aversion Capital ratio lender Capital ratio Ln(total assets) Bank has no rating (0-1) Rating Bank-specific characteristics

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

Simulated long-term spreads (basis points)

(basis points)

9Aug07- 13Sep08 24Jan05– 8Aug 07

17 4 “worst” vs. “best” banks (a)-(b) 4 poorly vs. highly capitalized banks 6 2 small vs. large banks 6 2 worst vs. best rated banks Estimated premium paid by 32 4 net of window dressing/accounting effects 12 3 net of effect of risk aversion Estimated cost of funds 37 5 Average cost of funds

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The interbank market after August 2007: what has changed and why? The interbank market after August 2007: what has changed and why?

The data:

6,480 5,314 14,279 20,750 Number of contracts 32.6 33.2 32.4 32.4 weig avg 39.0 38.9 35.6 36.6 mean Duration (days) 44 44 49 49 max 2 2 2 2 min 8 8 8 8 st dev 22 23 25 24 mean Daily average number of active participants 225.9 128.3 32 226 max

  • 12
  • 12
  • 6
  • 12

min 38.1 25.5 3 28 st dev 43.3 33.7 4 16.5 mean Spread (basis points) 3,067 3,067 2,495 3,067 max 10 20 3 3 min 425 418 405 416 st dev 572 580 686 646 mean Daily volumes (millions of euros) during crisis: with Lehman during crisis: no Lehman before crisis

  • verall

sample e-MID transactions