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Understanding Liquidity and Credit Risks in the Financial Crisis

  • Deborah Gefang

    ()

    (Department of Economics, University of Lancaster)

  • Gary Koop

    ()

    (Department of Economics, University of Strathclyde; The Rimini Centre for Economic Analysis (RCEA))

  • Simon M. Potter

    ()

    (Research and Statistics Group, Federal Reserve Bank of New York)

This paper develops a structured dynamic factor model for the spreads between London Interbank Offered Rate (LIBOR) and overnight index swap (OIS) rates for a panel of banks. Our model involves latent factors which reflect liquidity and credit risk. Our empirical results show that surges in the short term LIBOR-OIS spreads during the 2007-2009 financial crisis were largely driven by liquidity risk. However, credit risk played a more significant role in the longer term (twelve-month) LIBOR-OIS spread. The liquidity risk factors are more volatile than the credit risk factor. Most of the familiar events in the financial crisis are linked more to movements in liquidity risk than credit risk.

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File URL: http://www.rcfea.org/RePEc/pdf/wp45_10.pdf
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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 45_10.

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Date of creation: Jan 2010
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Handle: RePEc:rim:rimwps:45_10
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  1. John B. Taylor & John C. Williams, 2009. "A black swan in the money market," Proceedings, Federal Reserve Bank of San Francisco, issue Jan.
  2. Rajdeep Sengupta & Yu Man Tam, 2008. "The LIBOR-OIS spread as a summary indicator," Monetary Trends, Federal Reserve Bank of St. Louis, issue Nov.
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  8. Chib, Siddhartha, 1996. "Calculating posterior distributions and modal estimates in Markov mixture models," Journal of Econometrics, Elsevier, vol. 75(1), pages 79-97, November.
  9. Durbin, James & Koopman, Siem Jan, 2001. "Time Series Analysis by State Space Methods," OUP Catalogue, Oxford University Press, number 9780198523543, December.
  10. Tao Wu, 2008. "On the effectiveness of the Federal Reserve's new liquidity facilities," Working Papers 0808, Federal Reserve Bank of Dallas.
  11. François-Louis Michaud & Christian Upper, 2008. "What drives interbank rates? Evidence from the Libor panel," BIS Quarterly Review, Bank for International Settlements, March.
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