Analysing liquidity crashes and liquidity risk contagion in short-term interbank rates

Abstract

The financial crisis of 2007-08 is recognised to be the worst crisis since the Great Depression of the 1930s. As a result, liquidity risk and contagion perceived in the interbank market has gained increased attention. In this thesis, the LIBOR-OIS spread, the German-US bond spread, the Euro- dollar currency swap and the EONIA rate are studied to reveal causalities, interdependencies and regime changes in the short-term interbank market. Interbank markets are channels of contagion due to the overlapping claims banks have on one another. If liquidity dries up in the overnight market, as happened during the latest financial crisis, the domino effect transmits liquidity shocks to other markets. Through three distinct investigations, the main objective of this thesis is to investigate liquidity crashes and contagion in the short-term interbank market. The first analysis demonstrates that there is causality among the series and that they are also cointegrated, while structural breaks are detected in the identified long-run equilibrium relationships. To better identify the breaks, in the second analysis, a novel univariate two-state regime switching model is presented. The variability in the LIBOR-OIS spread along with thresholds of different levels reveal regime changes consistent with liquidity crashes. Thus, the model acts as an early-warning indicator of an imminent liquidity shortage striking the interbank market. Depending which state the system is in, the series is modelled either as a first-order autoregressive process, or as a Gaussian white noise process. Finally, a multivariate endogenous regime switching model describes how liquidity shocks drive the transition between crisis and non-crisis regimes. The investigation uncovers the self fulfilling nature of endogenous liquidity shocks and their propagation across markets before and during financial crises. Moreover, the results suggest that liquidity shocks originating from the LIBOR-OIS spread govern the dynamics of the system.

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ORCID for Andrew Urquhart: orcid.org/0000-0001-8834-4243

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