Liquidity Risk, Credit Risk and the Overnight Interest Rate Spread: A Stochastic Volatility Modelling Approach

22 Pages Posted: 17 Jul 2010

See all articles by John Beirne

John Beirne

European Central Bank (ECB)

Guglielmo Maria Caporale

Brunel University London - Department of Economics and Finance; London South Bank University; CESifo (Center for Economic Studies and Ifo Institute); German Institute for Economic Research (DIW Berlin)

Nicola Spagnolo

Brunel University London - Economics and Finance

Multiple version iconThere are 3 versions of this paper

Date Written: July 2010

Abstract

In this paper we model the volatility of the spread between the overnight interest rate and the central bank policy rate (the policy spread) for the euro area and the UK during the two main phases of the financial crisis that began in late 2007. During the crisis, the policy spread exhibited signs of volatility, owing to the breakdown in interbank market activity. The determinants of this volatility are assessed using Stochastic Volatility models to gauge the role played by liquidity risk, credit risk (financial and sovereign), and interest rate expectations. Our results suggest that liquidity risk is the main determinant of the volatility of the policy spread, but also that private bank credit risk has become more apparent in the post-Lehman collapse phase of the crisis for the euro area as financial CDS premia rose due to possible default fears. In addition, the ECB appears to have been more effective in addressing liquidity risk since the onset of the crisis, and this may be related to its greater direct access to a broader range of counterparties and its acceptance of a broader range of eligible collateral. The main implication is that, in crisis times, a sufficiently flexible operational framework for monetary policy implementation produces the most timely response to market tensions.

Keywords: Overnight Interest Rate Spread, Liquidity Risk, Credit Risk, Stochastic Volatility

JEL Classification: C32, E52, E58

Suggested Citation

Beirne, John and Caporale, Guglielmo Maria and Spagnolo, Nicola, Liquidity Risk, Credit Risk and the Overnight Interest Rate Spread: A Stochastic Volatility Modelling Approach (July 2010). DIW Berlin Discussion Paper No. 1029. Available at SSRN: https://ssrn.com/abstract=1641030 or http://dx.doi.org/10.2139/ssrn.1641030

John Beirne

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Guglielmo Maria Caporale (Contact Author)

Brunel University London - Department of Economics and Finance ( email )

Kingston Lane
Marie Jahoda Building
Uxbridge, Middlesex UB8 3PH
United Kingdom
+44 1895 266713 (Phone)
+44 1895 269770 (Fax)

HOME PAGE: http://www.brunel.ac.uk/about/acad/bbs/bbsstaff/ef_staff/guglielmocaporale/

London South Bank University ( email )

Centre for Monetary and Financial Economics
London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

German Institute for Economic Research (DIW Berlin) ( email )

Mohrenstra├če 58
Berlin, 10117
Germany

Nicola Spagnolo

Brunel University London - Economics and Finance ( email )

Uxbridge UB8 3PH
United Kingdom

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