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

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. We find a strong role played by liquidity risk volatility, but also private bank credit risk volatility after the collapse of Lehman Brothers. 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.