Liquidity Risk Contagion in the Interbank Market

33 Pages Posted: 3 Feb 2016 Last revised: 26 Aug 2016

See all articles by Andrea Eross

Andrea Eross

Heriot-Watt University

Andrew Urquhart

ICMA Centre, Henley Business School

Simon Wolfe

University of Southampton - School of Management; University of Southampton - Southampton Business School

Date Written: May 25, 2016

Abstract

This paper studies liquidity risk contagion within the interbank market by assessing the long-run relationship of short-term interest rate spreads from January 2002 to December 2015. In particular, we model the interaction between the LIBOR-OIS spread, euro fixed-float OIS swap rate and the three-month US-German bond spread and discover strong evidence of structural innovations affecting the interbank market. We find that when the short-term interbank market is affected by a liquidity shock, the LIBOR-OIS spread is a leader in moving back to equilibrium, while the euro fixed-float OIS swap rate and the US-German bond spreads are followers. Moreover, we find long-run cointegrating relationships and bi-directional causality between the spreads. However, structural breaks identified as prospective financial crises affect the long-run relationships and liquidity shocks drive interbank rates and spread fluctuations. Therefore, liquidity shocks propagating within the interbank market can forecast benchmark interest movements and ultimately this has significant implications for policymakers and market players alike.

Keywords: Interbank market, Liquidity shocks, Structural breaks, Financial crisis, Contagion

JEL Classification: C32, G15

Suggested Citation

Eross, Andrea and Urquhart, Andrew and Wolfe, Simon, Liquidity Risk Contagion in the Interbank Market (May 25, 2016). Available at SSRN: https://ssrn.com/abstract=2726734 or http://dx.doi.org/10.2139/ssrn.2726734

Andrea Eross (Contact Author)

Heriot-Watt University ( email )

Mary Burton Building
School of Social Sciences
Edinburgh, Midlothian EH14 4AS
United Kingdom

Andrew Urquhart

ICMA Centre, Henley Business School ( email )

University of Reading
Whiteknights
Reading, Berkshire RG6 6BA
United Kingdom

Simon Wolfe

University of Southampton - School of Management ( email )

Highfield
Southampton S017 1BJ, Hampshire SO17 1BJ
United Kingdom

University of Southampton - Southampton Business School ( email )

Southampton, SO17 1BJ
United Kingdom

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