A Black Swan in the Money Market

1. A Black Swan in the Money Market John B. Taylor Stanford University John C. Williams Federal Reserve Bank of San Francisco Federal Reserve Conference on Financial Markets January 2, 2009 The views expressed in this paper are solely those of the authors and should not be interpreted as reflecting the views of the management of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

2. Spreads on term inter-bank loans (relative to OIS) had been low and stable. In August 2007, spreads shot up and have been highly volatile since then. Spreads on CDs and term fed funds display same pattern. A Black Swan in the Money Market Libor: London inter-bank offer rate. OIS: Overnight indexed swap (proxy for average expected overnight rate)

3. Aim of Paper • Analyze and measure the roles of counterparty risk and liquidity risk in term inter-bank lending rates during the past year. • Evaluate effects of Term Auction Facility (TAF) on term lending spreads. • Our analysis covers the first year of the crisis (through August 2008).

4. Counterparty or Liquidity Risk? • Counterparty risk: late or non-payment of principal and/or interest. • We consider three measures of counterparty risk: bank CDS rates, Libor-Repo spreads, and Libor-Tibor spreads. • Liquidity risk: funds may be needed soon and hard to obtain elsewhere. Median 5-year Credit Default Swap (CDS) rates of 15/16 Libor banks.

5. Other Measures of Counterparty Risk Libor-Repo spreads Libor-Tibor spreads

6. Liquidity Measures:Term Auction Facility (TAF) • Goal: restore functioning of term inter-bank lending market, in part by reducing stigma associated with discount window borrowing. • 28-day collateralized (discount window) loans. • Sterilized by open market operations during our sample. • Synchronized with dollar loans from ECB and SNB.

7. Econometric Evidence:3-month Libor-OIS Spreads • We examine effects of our three market-based measures of counterparty risk and the TAF on three term spreads. • Theory is silent on timing of TAF effects on spreads, so we consider several alternative specifications. • First two specifications (OLS and AR(1)): Lending rate-OIS = constant + a*RISK MEASURE + 5i=1 bi*TAF AUCTION DUMMY(t-i)

8. Econometric Evidence • Based on three measures of term lending spreads and three measures of counterparty risk and two regression specifications: • Counterparty risk measures have correct sign and are in most cases statistically significant. • Estimated effect of TAF ranges between -29 basis points and +145 basis points; negative estimated TAF effect is statistically insignificant in only 1/18 cases (-13 bp).

9. Alternative Specifications • Are Libor-OIS spreads are lower since announcement of TAF than before, after controlling for CDS spread (Wu)? • Estimated effect of TAF ranges from -8 basis points to +44 basis points; negative estimated TAF effect is statistically significant in only 3 of 18 cases. • Do Libor-OIS spreads change following TAF “events” (McAndrews, Sarkar, and Wang)? • TAF events have statistically significant effects on Libor-OIS spreads in MSW specification. • But, results are NOT robust to choices of lending spread and definition of TAF operations dummy.

10. Conclusion and Postscript • Risk measures are economically and statistically significant predictors of term lending spreads. This is a robust finding. • We do not find similarly robust evidence of an economically and statistically significant effect of the TAF on spreads. • Since our sample ended, TAF has been greatly expanded and governments have recapitalized banks and introduced guarantees for some inter-bank lending. Term lending spreads are still very high.