1 INTERBANK MARKET AND LIQUIDITY DISTRIBUTION DURING

INTERBANK MARKET AND LIQUIDITY DISTRIBUTION DURING THE GREAT
FINANCIAL CRISIS: THE e-MID CASE
Gianfranco A. Vento* & Pasquale La Ganga**
September 4, 2009
Abstract
The paper analyzes the behavior of the Italian e-MID unsecured interbank market during the recent
financial turmoil, highlighting some peculiarities occurred in the last two years. The aim of the
research is to investigate how the operative solutions recently adopted by the e-MID may represent
a viable answer in order to improve the liquidity distribution. For this purpose, the paper examines
the interbank transactions within the euro area since the current financial crisis started, both in the
e-MID and in the over-the-counter interbank markets, pointing out if the introduction of an
anonymous and collateralized segment in the e-MID market since February 2009 may improve the
liquidity distribution within the euro area.
JEL codes: E58, G20
Index
1. Introduction
2. The fundamental dilemma of interbank market
3. Money market and liquidity crisis: some empirical evidence
4. The response of the Eurosystem
5. The e-MID case and the interbank market within the euro area
6. Which perspectives for the interbank market and liquidity distribution?
7. Conclusion
References
*
Università degli Studi “Guglielmo Marconi”, Faculty of Economics (e-mail: [email protected]).
Bank of Italy, Banking Supervion, Inspectorate Department (e-mail: [email protected]).
**
1
1.
Introduction1
For many years, the unsecured interbank market has been considered the archetypal of an efficient
market. In such a place, the participants are all professionals and, consequently, they are supposed
to be adequately equipped in order to assess the risks related to the market participation. The
efficiency of interbank market worldwide was also demonstrated by the high number of
participants, the significant degree of market breadth and depth , as well as by the narrow bid-ask
spreads.
Nevertheless, during the Great Financial Crisis, many of the certainties concerning interbank
markets suddenly disappeared, also affecting those financial intermediaries which were not
involved in subprime business. The fact that in the last years many large financial groups, mainly
based in the most advanced financial countries, used to adopt Originate-to-Distribute business
models increases, among others, the strategic significance of the global interbank market. Actually,
the adoption of O-t-D models on large scale imposes to have an efficient interbank market on which
banks and Special Purpose Entities (SPEs) can easily, and without additional costs, raise the
necessary funds in order to manage their liquidity mismatching.
However, since the summer 2007 a deep liquidity shortage affected the interbank markets all over
the world, producing consequences that does not concerned the financial intermediaries’ liquidity
management only.
The aim of the paper is to analyze the operative solutions recently adopted by the e-MID interbank
market for the unsecured interbank transactions. For this purpose, the paper analyses the interbank
transactions within the euro area since the current financial crisis started, both in the e-MID and in
the over-the-counter interbank markets, pointing out if the introduction of an anonymous and
collateralized segment in the e-MID market since February 2009 can represent a viable answer in
order to improve the liquidity distribution within the euro area.
The paper is organized as follows. Section two reviews the most significant literature on both some
externalities, and their effects, on the money market malfunctioning and the different structural
options in the interbank market. Section three analyses the most considerable shocks which affected
the market since summer 2007, deepening the effects on volumes and interest rates, in order to
verify why the usual efficiency assumptions have been not respected. In section four we briefly
1
The authors are particularly grateful to Salvatore Abbatiello for his very useful support in providing the data about the
e-mid transactions. They also thank Francesco Cesarini, Michael Gavridis, Wolfgang Munchau, Giacomo Oddo, Franco
Tutino, Valerio Vacca, Umberto Viviani and the participants at the seminar on “Monetary Policy & Bank Liquidity:
Crisis Management” at the Regent’s College for useful discussions and suggestions. The opinions expressed in this
paper do not necessarily correspond to those of Bank of Italy. All errors remain the responsibility of the authors.
Despite this paper is the result of a research jointly carried on by the authors, sections 1, 4, 5 and 7 can be attributed to
Gianfranco A. Vento, while sections 2, 3 and 6 has been written by Pasquale La Ganga.
2
summarize the most considerable responses of the European Central Bank (ECB) in order to restore
the confidence in the interbank market. This part critically analyzes the proactive role that the
European Central Bank had in liquidity management during the crisis. The fact that banks preferred
to deal with central banks rather than with other market participants during the turmoil had
important implications in order to avoid systemic effects from the crisis. However, such a market
equilibrium with a major role of central banks in the interbank market cannot be considered
efficient in the medium and long term and must be rethought. The following section is dedicated to
the European interbank market and focuses on the e-MID case. Before the crisis, this unsecured
interbank market has been demonstrated to be a more efficient solution for banks in order to
smoothly manage the liquidity shortages. On the other hand, the e-MID has some intrinsic features
(i.e. transparency), which represented a limit for the market participation within the recent financial
turmoil. In response of that, in February 2009 the company that manages the e-MID launched a new
segment for interbank transaction, called “MIC”, which is collateralized and anonymous. Section
six explores the perspectives for interbank channel, starting from the unexpected reactions of such
markets during the crisis. Last, section seven highlights some conclusions.
2.
The fundamental dilemma of interbank market.
The interbank market, especially that for unsecured overnight loans2, plays at least a crucial role
both in the transmission of monetary policy and in redistributing liquid assets within the financial
system. Policymakers are interested in having a robust and smooth functioning interbank market,
that is, one in which the central bank can achieve its desired rate of interest and that allows
institutions to efficiently trade liquidity. In normal times, through such network central banks guide
their policy interest rates in order to affect inflation rate and the real economy. As highlighted by
Freixas et al. (2009) this traditional view based on the complete separation between monetary and
financial-stability policy is challenged by observations that during a banking crisis, more than ever
after the second half of 2007, interbank interest rates often appear to be used by central banks for
limiting threats to financial stability. By steering very short-term money market interest rates to
keep them close to their official rates and using their regular monetary policy operations, central
banks try to influence the longer-maturity rates that are relevant for bank loan rates.
2
The average interest rate on overnight loans is the overnight rate, which is the short-term market interest rate, and such
has a crucial role in term structure models. It also lies at the heart of monetary policy (Bernanke and Blinder, 1992).
3
A deep and liquid interbank market supports the main purpose of financial intermediation, that is
the channeling of funds from savers to investments3. The banks’ ability to withstand liquidity
shocks and to provide lending to one another is crucial for both financial stability and real economy
since strains in the interbank money market can make pressure on the financing conditions faced by
non-financial corporations and households which, in turn, lead to higher credit risk.
At a microeconomic level, intermediaries (mainly banks) re-allocate liquidity (originally supplied
by the central bank within the banking system at the rate decided upon by central bank) through the
interbank market, such that those institutions with liquidity excess transfer their funds to those with
deficits4. A redistribution of funds, primarily by overnight lending, between banks may be
necessary to cope with both expected and unexpected liquidity needs5, risk sharing purposes or
simply because banks are heterogeneous and specialized in different activities6.
At a macroeconomic level, the interbank network reinforces financial integration, while increasing
bank connections and the exposure to systemic risk 7. Some well-known features of the banking
business make it likely that a system-wide banking crisis materializes first and foremost as a sudden
deterioration in trust. The most evident sign of this pattern is the bank run, which may strike both
troubled banks as well as those that would otherwise be sound. For instance, in the market for
interbank deposits trust plays a considerable role if one considers that deposits on the leading
overnight maturity are typically uncollateralized. Because of this prevailing maturity, every day the
lender sets if to extend new credit or not, that is whether to renew its confidence in the borrower.
The literature reviewed for supporting the empirical analysis carried out in this paper can be divided
into two groups: the first one focuses on the informative asymmetries and adverse selection
problems and their effects on the money market malfunctioning during the financial crisis; the
second one gathers the money market structures and their linkage with contagion and systemic risk.
As underlined by Iazzetta and Manna (2009) in good times the interbank market provides banks
with a form of coinsurance against uncertain liquidity flows, while in bad times it acts as a vehicle
in spreading the crisis 8. Hence, this market suffers a trade-off between mutual insurance and
3
In the traditional view, banks take in deposits from a large number of consumers and shift these funds to profitable
investment projects. See Bini Smaghi (2008).
4
This reduces the need for each bank to hold large quantities of liquid assets, thus releasing funds for more profitable
lending transactions.
5
A financial institution faces liquidity risk when it lacks access to cash needs in order to face their debt obligations or
deposit withdrawals.
6
The interbank lending represents one form of safety net for individual banks.
7
Systemic risk is the risk of collapse of an entire financial system or entire market. This tendency for crises to spread
within a market is strictly connected to interlinkages and interdependencies. De Bandt and Hartmann (2000) and
Kaufman (1994) provide a detailed discussion on the definition of systemic risk.
8
“Furthermore, the potential for contagion of the crisis from a first bank to the system is magnified by the practice of
major players to act simultaneously as lenders and borrowers in this market. As a result, the halt in the operations of
one of them triggers two knock-on effects. The banks that have lent to the failed one will recover, at best, only part of
4
systemic risk on the overall stability of the system under interbank lending: it helps to reallocate
liquidity and thus strengthening the system, but doing so it increases its exposure to contagion risk.
The importance of interbank markets as distributors of liquidity, mainly in order to insure against
idiosyncratic shocks arising from the behavior of retail depositors, is well recognized in more or
less contemporary empirical literature.
A few studies, starting from Akerlof’s contribution (1970), extend the asymmetric information
approach to the credit market (Stiglitz and Weiss, 1981) and to the interbank market. The latter may
fail to allocate liquidity efficiently because of some externalities, above all adverse selection
problem and asymmetric information about the quality of banks’ assets.
Flannery (1996) presents a model of private lending which identify a crisis as a stage when lenders
become uncertain about how to assess financial risks, and therefore rationally withdraw from
making new loans9.
In a recent work, Heider et al. (2008) focus on the credit risk problem that asymmetric information
introduces when a bank’s probability of default cannot be directly observed by “outsiders”. If the
adverse selection problem is negligible there is full participation. In that case, if credit risk is
significant for some banks and this is reflected in a higher interest rate for all banks, safer borrowers
drop out of the market. Vice-versa, when the above mentioned market process is severe the market
breaks down either because lenders prefer to hold on their funds or because borrowers find too
expensive to borrow. In order to analyze rigorously the effects of interbank markets imperfections
on monetary transmission, Freixas and Jorge (2007) show that, under asymmetric information, the
interbank market is unable to efficiently channel liquidity to solvent illiquid banks. As a
consequence, asymmetric information can generate rationing in the bank loan market and helps
justifying the liquidity effect10.
The framework by Freixas and Holthausen (2004) deals with possible cross-border integration of
interbank markets in the presence of asymmetric information about bank solvency. They model a
banking sector in which banks face individual shocks as in Diamond and Dybvig (1983), where
depositors are ex-ante uncertain at which point in time they need to consume. The difference in
liquidity shocks across banks justifies the existence of an interbank market where banks can insure
themselves against these distresses.
their loan; in addition, the banks which used to borrow from the defaulted one will need to seek new funding parties,
something which may not be straightforward at times of crisis. Thus, the default of a bank may cause both credit losses
and a loss of liquidity for the market as a whole, two patterns also referred to as the exposure contagion channel and
the credit line contagion channel” (Iazzetta and Manna, 2009).
9
In such an environment, a government lender of last resort can improve social welfare.
10
In an asymmetric information framework, the interest rate effects combine with those of credit rationing and reinforce
one another.
5
Liquidity allocation could be inefficiently because of banks’ free-riding on each other’s liquidity or
on central bank liquidity too.
Bhattacharya and Gale (1987) suggest that interbank market trading provides insurance against
inter-temporal liquidity shocks, although there are some distortions resulting from the
implementation of this structure. Intermediaries can collectively provide extra liquidity by
borrowing and lending after their liquidity needs are known; that is to say, they have an incentive to
set up an ex-post interbank market. However, there is a “free-rider” problem: in a competitive
market for interbank loans the ready access to the market increases the incentive for participating
banks to not invest ex ante in liquid assets.
Brunnermeier and Pedersen (2005) show that “predatory behavior” forcing inefficient liquidation of
bank assets may jeopardize the effective liquidity allocation in the interbank market11. Predatory
trading enhances systemic risk, since financial shock to one trader may spill over and trigger a crisis
for the whole financial sector12.
A further branch of research is represented by theoretical contributions on contagion models
depending on the interbank market’s structure that may influence the severity of contagion13. Iori et
al. (2006) show that in a simulated model of heterogeneous trading banks, the network framework
is crucial to guarantee the stability of the overall system. Allen and Gale (2000) have highlighted
that the propagation of shocks within the interbank market (and to the entire economy) is dependent
on the exact pattern of banks’ financial linkages. They identify two key structural characteristics of
the market which affect financial contagion: market completeness and interconnectedness14. In their
theoretical model they show that complete market structures are less prone to contagion, although
the level of connectedness is also important15.
11
Brunnermeier and Pedersen (2005) provide a framework for studying this phenomenon showing that risk
management strategy should take into account “predatory trading”. These actions lead to price overshooting and
amplify a large trader’s liquidation cost and default risk.
12
To this aim their analysis support the value of coordinated actions by regulators or bailouts.
13
Contagion models can be classified in three categories. The first group explores the probability of reduction in asset’s
value of the whole system due to sales made by institutions facing liquidity shortages (see Estrada and Osorio (2007)
and Cifuentes et al. (2005) for further empirical evidence). The second considers that contagion risk depends on the
structure of the interbank market (see Nier et al. (2007), Allen and Gale (2000) and Boss et al. (2004)). The third
highlights that individual liquidity risk could be transformed into systemic risk when the failure of one bank or a small
set of banks is transmitted to other banks through explicit financial relations among banks (see Furfine (1999) and
Upper and Worms (2002)).
14
A market is complete if each bank lends to all the others. On the other hand, a market is perfectly interconnected if
each bank is financially linked to all the others, regardless of the kind of linkage, which may be both direct (i.e. each
bank lends to all the others) and indirect (the link that a bank could indirectly establish with another if a third one is
linked to both of them).
15
These authors conclude that if the interbank market is complete, the effect caused by an unexpected shock in a bank
can be absorbed by a big number of banks, which reduces intensity of the shock. Nevertheless if the market is
incomplete the initial shock in a bank can only be transmitted to its neighbors, but in a larger magnitude which would
lead to a transmission of the distress bank to bank across the financial system. This suggests that a market with a
complete structure is less susceptible to a shock.
6
Freixas et al. (2000) distinguish another structure, named money centre. They show that in that case
when a bank failure occurs and it is connected to the money centre there is no effect on the same
money centre16. However, if the monetary centre is the one that fails, this shock could be
transmitted to the banks connected to it (Tab. 1).
Table 1. Matrices for different type of interbank market structures
Source: Estrada and Morales (2008).
Dispersion is an important characteristic to understand the structure of an interbank market. As
shown by Lubloy (2004), dispersion of interbank assets and liabilities (xij) can be measured as:
xij =
ai ⋅ l j
∑
N
ij
xij .
The terms in the above equation are captured by the following matrix (Tab. 2):
Table 2. Matrix X of interbank exposures
Source: Lubloy (2004).
The matrix X shows the bilateral exposures of banks, where xij is interbank assets of bank i from
bank j, ai is total interbank assets of bank i, and lj is total interbank liabilities of bank j.
Concentration makes reference to the degree of focus of interbank transactions by a small number
16
The money centre is symmetrically linked to other banks of the system, but those other institutions are only linked
together through the money centre.
7
of banks. In order to determine the level of concentration through the time of analysis, some authors
determine the Herfindahl-Hirschman Index (HHI)17.
Dealing only with uncollateralized transaction on Italian interbank market we calculated the
Lubloy’s dispersion matrix on 31 December 2008 (Tab. 3) using the supervisory statistical reports
transmitted to the Bank of Italy by 9 banking groups, numbered from 1 to 9. They represent about
the 68% of the total unsecured interbank exposures.
Table 3. Italian interbank market matrices
Group 1
Group 2
Group 3
Group 4
Group 5
Group 6
Group 7
Group 8
Group 9
Other
Group 1
0,1
37,6
0,5
170,3
0,9
4,2
3,4
3,8
33,2
28,2
Group 2
13,5
3.999,1
48,8
18.091,2
97,6
443,9
363,9
406,8
3.523,9
2.995,8
Group 3
0,2
71,6
0,9
323,9
1,7
7,9
6,5
7,3
63,1
53,6
Group 4
8,3
2.461,7
30,1
11.136,4
60,1
273,2
224,0
250,4
2.169,2
1.844,1
Group 5
0,0
0,3
0,0
1,4
0,0
0,0
0,0
0,0
0,3
0,2
Group 6
0,1
27,6
0,3
124,8
0,7
3,1
2,5
2,8
24,3
20,7
Group 7
0,4
114,4
1,4
517,6
2,8
12,7
10,4
11,6
100,8
85,7
Group 8
0,2
68,5
0,8
310,0
1,7
7,6
6,2
7,0
60,4
51,3
Group 9
0,0
11,1
0,1
50,4
0,3
1,2
1,0
1,1
9,8
8,3
Other
0,6
170,9
2,1
773,2
4,2
19,0
15,6
17,4
150,6
128,0
Data Source: Bank of Italy’s supervisory reports.
According to this measure, contagion probability is low even if we observe a slight increase since
the beginning of 2007. In order to assess the structure of the Italian interbank market from another
standpoint, we construct a matrix showing the average size of interbank assets and liabilities for
each banking groups from December 2008 to June 2009. They are randomly numbered from 1 to
80. The color of each cell specifies the relationship’s strength between two groups. For example the
green cell in the intersect of eleventh row and second column shows that the second bank borrowed
funds from 0,5 to 20 million euro on average from the eleventh bank. As shown in table 4, the
structure of the Italian interbank market is similar to a multiple money centre.
17
The HHI is a commonly accepted measure of market concentration. It is calculated by squaring the market share of
each intermediaries competing in the interbank market and then summing the resulting numbers.
8
Table 4. The matrix of the average size of Italian interbank market assets from December 2008 to 30 June 2009.
Data Source: Bank of Italy’s supervisory reports.
9
In the last decades the interbank markets have been considered an example of efficiency and selfregulation. In such a framework, the liquidity used to be abundant, counterparty risks were
considered not significant and the monetary authorities were able to modify the interest rate level in
almost all the yield curve. In the aggregate, the interbank market only redistributes liquidity across
banks; it does not create liquidity18. If this segment of wholesale money market is having liquidity
shortages, intermediaries must go to the central bank for the resources, assuming a higher rate. In
absence of central bank’s intervention, liquidity pressures on the banking system could bring a big
number of banks into being defaulted, thus the financial system may end-up collapsing 19.
Developments in financial technology and markets since the 1980s have in many ways increased
the importance of the international interbank market and the moral hazard problem confronting
central banks, not only in the academic literature. Central banks seemed to face a potentially large
contingent liability to the international banking system. The reason is the growing need for
“liquidity” in financial markets, the necessity to allocate this liquidity quickly and efficiently and to
provide assurances that it will be available in times of market stress. It looked as if there was a
certain degree of complacency with respect to systemic risk. This appeared to be fostered by a more
or less firmly held belief that central banks or public authorities would act to prevent any
disruptions from reaching systemic proportions. A number of participants maintained that the
confidence with which this conviction is held acted to stabilize markets. The perception of the
presence of implicit guarantees supporting the channel of interbank lending increased over time, so
reducing the evaluation mechanism of credit risk evaluation in such a market. This awareness that
the market believed would be supported by their respective central banks20 reduced the incentives
for market participants to closely monitor counterparty risk even if, operating on this market, banks
gain valuable information on bank counterparties21. As a consequence, weak intermediaries could
raise funds at the same conditions achieved by bigger and better equipped banks, whereas the
18
As argued by Goodfriend and King (1988), with efficient interbank markets central banks should not lend to
individual banks but should instead provide sufficient liquidity via open market operations which the interbank market
could then allocate efficiently among banks.
19
According to Gonzalez and Osorio (2006), when there is a systemic shock, interbank's liquidity acts as a constraint to
solve individual liquidity shortages. In this same context, if liquidity supplying entities in the interbank market face a
liquidity shock, due to higher than expected deposit withdrawals, then the aggregate liquidity supply would be reduced;
hence affecting liquidity demanders. The latest won't be able to obtain the funds needed from the interbank market.
20
As reported by Clarke (1983), from its beginning, a common perception has been that the international interbank
market was “special”, in that deposit placements were in large banks “that the market believed would be supported by
their respective central banks and that veiled the operations of individual customers in secrecy. Moreover, the history of
cooperation among the monetary authorities of the major countries provided a basis for the markets’ belief that no
large institution chartered in one of those countries would be allowed to fail even where a large volume of its liabilities
were denominated in a foreign currency”.
21
For a long time policy makers and academic economists have periodically expressed concerns over what appeared to
be the lax standards of credit analysis in the interbank market.
10
interest rates on unsecured interbank deposit used to be in line with those offered by central banks
on secured deposit.
In theory, the liquidity premium on interbank exposure could be lower in the light of the provision
of central bank liquidity through a variety of channels. On the supply side, banks that have a greater
assurance of matching their own unforeseen liquidity needs over time should be more willing to
extend term loans to other banks. In addition, creditors should also be more willing to provide
funding to banks that have easy and dependable access to funds, since there is a greater reassurance
of timely repayment. On the demand side, with a central bank liquidity backstop, banks should be
less inclined to borrow from other banks to satisfy any precautionary demand for liquid funds
because their future idiosyncratic demands for liquidity over time can be met via the backstop.
However, assessing the relative importance of these channels is difficult.
The fundamental dilemma in the interbank market resulted from implicit guarantees which would
be necessary to sustain the market. These guarantees act much like as a domestic deposit insurance.
They had the undesirable effect of lowering the scrutiny of potential borrowers credit risk exercised
by lending banks. Later in this paper we will argue that because of the severe adverse selection
problems in the international interbank markets, certain segments might collapse without
guarantees. More recently, we have seen implicit guarantees turn into explicit guarantees of
international interbank deposits.
3.
Money market and liquidity crisis: some empirical evidences
Over the past few months the world has been witnessing financial market turmoil of global
dimensions known as the “subprime crisis”; it has been discussed extensively in the specialized
press and in official publications during last months. It had already caused bank failures, a
temporary freeze on money markets and sharp drops in equity market worldwide, forcing
governments and central banks to step in with drastic measures.
Several dimensions of subprime crisis has been explored such as lack of sound risk management
practices, need of credit rating methodologies to capture the risks embodied in the new financial
instruments, weaknesses in the application of accounting standards and great opacity associated
with the valuation and financial reporting of structured products, the need to adapt some of the
supervisory tools and practices to manage liquidity and cross-border differences in emergency
liquidity frameworks and to adequately account for the risks associated with new financial
instruments. Since the second half of 2007 the functioning of international interbank money
11
markets was severely impaired exhibiting unusual signs of stress around the world 22. Money market
interest rate soared within a few hours, and lending activity dried up. Virtually both all segments
and maturities of the money market were affected.
Uncertainty about losses associated with U.S. mortgage-backed securities and other forms of
structured credit continued to accumulate led large banks to revise upwards their liquidity needs
while making them also more reluctant to lend to each other, in particular at longer maturities23. In
such situation, banks were no longer able to obtain funds in the money market independently of
their creditworthiness. After a period of normalization, in September 2008 several defaults and bail
outs of systemic financial institutions reinforced general concerns about solvency and the liquidity
situation. Two types of interest rate spreads are especially helpful in tracking events as they have
unfold: the spreads of 3-month European interbank offered rate (Euribor24) over the overnight index
swap (OIS) and spreads on credit default swaps (CDS)25.
With the start of the financial market turbulences in August 2007 risk premia in short-term money
market rates, a standard measure of interbank market tensions, as represented by the spreads
between Euribor and overnight-indexed swap (OIS) rates increased significantly in most major
currencies (Graph 1) 26.
Graph 1. Evolution of spreads between Euribor and overnight-indexed swap (OIS) rates over 3 months
200
180
160
Spread Euribor /OIS 3M
140
120
100
80
60
40
20
30/06/09
31/03/09
31/12/08
30/09/08
30/06/08
31/03/08
31/12/07
30/09/07
30/06/07
31/03/07
31/12/06
30/09/06
30/06/06
31/03/06
31/12/05
30/09/05
30/06/05
31/03/05
31/12/04
0
Data source: Bloomberg
22
Similar strains emerged in many developed economy interbank markets, not least those of the United States, Europe,
United Kingdom, Switzerland, Canada, Australia and, to a lesser extent, Japan.
23
Although US sub-prime mortgage default rates, and the spreads on associated securities, had been rising since late
2006, the first significant event in the broader financial market turmoil seems to have been the emergence of rumors
during the third week of June 2007 about heavy losses in two hedge funds managed by Bear Stearns.
24
Euribor rates are widely used as reference rates in financial instruments such as variable-rate home mortgages and
corporate notes
25
The former is a good indicator of liquidity in interbank markets and the latter of credit risk premia.
26
Overnight-indexed swaps (OISs) are a proxy for expected future overnight rates. The counterparty risk associated
with these contracts is relatively small as they do not involve the exchange of principal; moreover, the residual risk is
further mitigated by collateral and netting arrangements. Furthermore, the liquidity premia contained in OIS rates
should be very small as these contracts do not involve any initial cash flows. Under normal market conditions, OIS rates
tend to be slightly below the corresponding Libor.
12
What is evident analyzing spreads on CDS is that concerns about counterparty risk became
extraordinarily intense (see Graph 2).
Graph 2. Itraxx Index (Generic 5 year Europe financial subordinated)
450
400
ITRXEUE CBGN Curncy
350
300
250
200
150
100
30/06/2009
31/03/2009
31/12/2008
30/09/2008
30/06/2008
31/03/2008
31/12/2007
30/09/2007
30/06/2007
31/03/2007
31/12/2006
30/09/2006
30/06/2006
31/03/2006
31/12/2005
30/09/2005
30/06/2005
31/03/2005
0
31/12/2004
50
Data source: Bloomberg
Asymmetric information about counterparty risk as an underlying friction can also rationalize the
prolonged nature of interbank market tensions and the following level achieved by interbank
interest rates in the current financial turmoil, despite an unprecedented increase in the liquidity
provision by central banks 27. Thus, it is reasonable to affirm that the level achieved by interest rates
in the developed economy interbank markets in the last two years cannot be explained alone by an
increase in the counterparty risk premia only due to a higher default probabilities of market
borrowers. These rates are due to a liquidity risk premium, related to the so -called “liquidity
hoarding”. In other words, banks having a surplus of funds were not available to lend to other
banks, and accumulated liquidity well above their current and expected needs, due to the perception
that the liquidity in the interbank markets could dry up suddenly.
As the financial crisis deepened in September 2008, with an additional increase in the level and the
dispersion of counterparty risk, liquidity in the interbank market has further dried up as banks
preferred hoarding cash instead of lending it out even at short maturities. Under the turmoil, banks
have quite probably applied stricter lending limits in the overnight inter-bank market. The
remaining cash has been parked with the Eurosystem which plays the role of a risk-free
counterparty without lending limits. Refinancing from the ECB implies that banks are willing to bid
up tender rates revealing high degree of funding risk (aversion or premium) and market
27
Asymmetric information about counterparty risk creates frictions in the interbank market as suppliers of liquidity
protect themselves against lending to “lemons” (see Hider et al., 2009).
13
segmentation. Furthermore, analyzing the data on the secured segment of the interbank markets in
the same period it is possible to find some evidences that the cost of collateral played a considerable
role in short-term interest rates. Dealers in mortgage-backed securities and in over-the-counter
(OTC) derivatives started asking for more collateral from their counterparties. Securities accepted
by risk managers were a subset of the more extended ECB collateral, due to the less “risk
adversion” of central bank. In repo markets, lenders sharply increased their margin calls and refused
to accept as collateral anything but US Treasury securities or German bunds. Since bond dealers
finance themselves in the repo markets, they abruptly withdrew from making markets in the broader
fixed-income markets. Liquidity in US and European fixed-income markets seemed to evaporate
overnight. Trading on the interbank markets for maturities longer than overnight contracted sharply
in recent months and risk premiums reached very high levels due to a sharp market-wide
reassessment of risk in the summer of 2007, after subprime-mortgage backed securities were
discovered in portfolios of banks and bank-sponsored conduits, and a further increase in the level
and the dispersion of counterparty risk following the Lehman’s default in September 2008.
4.
The response of the Eurosystem
Due to the above-mentioned shocks within the interbank markets, during the Great Financial Crisis
monetary policy authorities worldwide were forced to implement special measures addressed to
maintain an acceptable level of liquidity distribution and, consequently, to avoid a collapse of
financial systems. This section critically analyzes the most significant response of the European
Central Bank (ECB) in order to restore the confidence within the euro area interbank market.
The Eurosystem’s actions to contrast the markets’ crisis and facilitate the liquidity distribution
among banks can be divided in five stages28 (Tab. 5).
At the beginning of August 2007, when conventionally the financial crisis started, the world
economy used to come from a prolonged expansion period. In this framework, the central banks
used to adopt a partially restrictive monetary policy, also because of the fear for the explosion of the
properties bubble in the United States. On August 9th three funds managed by BNP Paribas
informed to be unable to repay the investors, by selling asset-backed securities; subsequently, the
apprehension begun in the market of US mortgage-backed securities suddenly affected the euro
area, as well as other segments of the financial market.
In such a context, doubts on the counterparties’ solvency in the interbank market and a generalized
increase of the liquidity risk pushed the overnight interest rate in the euro area from 4.10% to
28
For a detailed overview on the Eurosystem’s monetary policy during the crisis see European Central Bank (2009a),
chap. 1 and Banca d’Italia (2009), chap. 7. On the origins and causes of the crisis see Vento and La Ganga (2009).
14
4.70%. The European Central Bank, in the first stage, tried to contrast the tensions by means of the
usual monetary policy tools. Thus, the ECB immediately intervened in order to ensure normal
conditions in the euro area money market: it injected additional liquidity through overnight fine
tuning operations, arranged two extraordinary longer-term refinancing operations (LTROs) and
increased the liquidity to put in the system through main refinancing operations (MROs). In the
very first phase of the crisis, up to mid September 2007, the European Central Bank tried to restore
the confidence in the markets; nevertheless the ECB in its communications continued to remind its
statutory goal of price stability in the medium-term.
Table 5. The different stages in the Eurosystem’s monetary policy during the crisis
Period
Main Actions
Stage 1
Stage 2
Stage 3
Stage 4
Stage 5
Up to mid Sept 2007
Mid Sept 2007 to mid
Mid Sept 2008 to
October 8 th 2008 to
May 7 th 2009 to July
Sept 2008
October 8 th 2008
May 7 th 2009
2009
•
•
Usual monetary
•
Frontloading
policy tools
approach
Unusual
main
operations and
refinancing
amounts
•
•
in
Special
fine
•
tuning
•
•
Increase
corridor
operations
the volumes
standing
Stronger
of
facilities
coordination
refinancing
among central
operations
main
Interest rates at
minimum
•
Narrower
in
banks
rate
cuts
operations
•
Interest
on
Direct
purchase
of
covered bonds
interest rate
•
Fixed
rate
main
refinancing
operations
with
full
allotment
In the second stage, which goes from mid September 2007 to mid September 2008, the money
market registered an unusual volatility, as above illustrated, producing severe consequences on
banks’ liquidity management. Liquidity in interbank market rapidly disappeared and the traded
liquidity volumes had a significant reduction. Another measure of the increase in liquidity risk
within the analyzed period can be obtained from the spreads between Euribor (based on interbank
an average of transactions without collateral) and Eurepo (calculated as an average of collateralized
interbank loans) rates. There spreads, usually around 10 basis points within the euro area, reached
90 basis points at the end on 2007, remaining on values well above the usual values.
In such a situation, the European Central Bank decided to adopt a so-called frontloading approach
in the main refinancing operations, by which the monetary policy authority supplies greater
amounts of liquidity at the beginning of the reserve maintenance period, and reduces the liquidity
surplus in the last days on the maintenance period. Also the amounts offered in the longer-term
refinancing operations registered an increase and, more generally, the ECB utilized a more flexible
15
approach in the usual operations, due to the turmoil. Furthermore, in order to offer longer-term
funds to the banking system, which were virtually disappeared in the money market, the
Eurosystem in April and July 2008 arranged two longer-term refinancing operations having six
months maturity as well as revolved the extraordinary operations made at the beginning of the
crisis. Last, the dimension of the turmoil within the money markets and the increased systemic risk
induced the most important central banks to a greater coordination of monetary policies; in
December 2007 the ECB signed some agreements with the Federal Reserve addressed to make
possible the liquidity transfer in euro and US dollars, through swaps, in order to reduce the tensions
in short-term markets. Particularly, the Eurosystem facilitated the Term Auction Facilities of the
Federal Reserve, offering dollars against eligible collateral for its own refinancing operations. These
cooperation agreements have been renewed and expanded during 2008.
In general, despite the pressure within the interbank market and the funding difficulties of many
banks which used to depend on it, in the examined period the ECB organized many operations
aimed at bypassing the crisis, but also reminded its key focus on the statutory goal of price stability.
In this framework, after maintaining the interest rates on MROs unaltered since the beginning of the
crisis, in July 2008, with a strongly critiqued decision, the European Central Bank decided to
increase the official interest rates of 25 basis points, in order to face the potential inflation pressures
registered by the central bank.
In this period, the excess liquidity reserves detained by banks were in line with the levels before the
crisis, witnessing that, in the first stages there was not a generalized difficulty to raise interbank
funds, but a higher selectivity in the assessment of counterparty risk within the interbank market, as
well as an overall increase of liquidity risk premia29.
The third stage is identified in the period that goes from mid September 2008 to October 8th 2008.
In mid September there were the sold out of Merrill Lynch and the default of Lehman Brothers, two
of four global investment banks so far survived to the turmoil. In particular, the Lehman Brothers
default, happened on September 15th, ingenerated significant fears of a systemic crisis; in such a
framework, there were considerable increases in counterparty risks, a rapid growth of the spread
between unsecured and secured operations, a quick decrease of the volumes in the unsecured
interbank markets (in absence of official data on the unsecured interbank markets, the volume
reduction on e-MID market can be assumed as a proxy of the overall decline in interbank
transactions within the euro area), while the collateralized interbank loans registered an important
expansion (Graph 3).
29
As reported by Banca d’Italia (2008), the excess reserves used to be in line with the values before the crisis; at the
same time, the banks with worst ratings started to pay higher interest rates on interbank markets.
16
Graph 3. Volumes on e-MID and General Collateral repo
Source: Banca d’Italia (2009).
In order to restore the confidence in the money market the European Central Bank, between
September 15th and 24 th arranged four special fine tuning operations, injecting € 165 billion in the
system; at the same time, the ECB increased the volumes distributed through the main refinancing
operations.
The fourth stage of the crisis, which goes from October 8th 2008 to May 7 th 2009, represented the
most complex period for the Eurosystem, either in order to prevent a money market collapse and for
the monetary policy decisions. After the Lehman Brothers failure, in order to face the turmoil and
the concrete menace of a global systemic crisis, the ECB demonstrated, at the beginning, a
reluctance to modify the official rates, which after the increase of July 2008 where increased at
4.25%. Particularly, on October 2nd the European Central Bank decided to maintain the rates
unchanged, justifying such decision because, despite the economic slowdown, the annual inflation
rates would have been above a level coherent with price stability. Only six days later, in a context of
a virtually blocked money market, the ECB started an interest rate reduction process which brought
the interest rates on main refinancing operations to 1%, the lowest level ever reached. In the press
communicate of October 8th the European Central Bank modifies its previous analysis about
inflation perspectives, affirming that the risk of an inflation increase were recently reduced30. The
decision of the ECB to cut interest rates was coordinated with the central banks of U.S.,
Switzerland, Canada, U.K. and Sweden, which adopted similar measures.
On October 8th, in the same meeting, the Board of the ECB implemented two further temporary
measures, which had an essential importance in order to restore the correct functioning of the
interbank market. First, the ECB decided to reduce from 200 basis points to 100 basis points the
corridor between the standing facilities (marginal lending facilities and deposit facilities), so
30
See the ECB communicate (http://www.ecb.int/press/pr/date/2008/html/pr081008.en.html).
17
reducing to only 50 basis points the spread between the minimum rate on main refinancing
operations and the two standing facilities. This action was necessary because the huge liquidity
amounts injected by the European Central Bank were not distributed within the interbank market:
banks in the euro area, scared to be unable to raise funds on interbank market in case of necessity,
used to hoard liquidity over their current and expected needs. In absence of alternative liquid and
safe investments, the treasurers in the euro area used to deposit excess reserves in the Eurosystem’s
deposit facilities. This measure, revoked since January 21st 2009, made possible to contain, in the
most acute moments of the crisis, the volatility of overnight interest rates (measured, for instance,
by the EONIA rate), to reduce the opportunity cost of excess reserves, but also decreased the cost of
marginal lending facilities, become less costly than in the past.
The other important measure agreed by the ECB on October 2008 was to manage the main
refinancing operations – at least up to the end of 2009 – through fixed interest rate tenders, with a
full allotment at the rate fixed by the ECB. Given the severity of the situation in October 2008, the
ECB decided to temporally renounce to control the quantity of money, so concretely putting in
discussion its strategies for controlling inflation. In the same month, the allotment procedure based
on fixed rates, without amount limits, has been extended to longer-term refinancing operations.
These choices represented an extreme effort of the ECB to react at the interbank market
inefficiencies, becoming available to supply any liquidity amount at a fixed rate, provided the
counterparties had an adequate amount of eligible collateral.
In the examined period, furthermore, the European Central Bank established to help banks in
participating at Eurosystem’s operations and facilities expanding the potential collateral for
monetary policy operations, reducing to BBB- the minimum rating for assets to be accepted,
whereas the minimum rating for new emissions of asset-backed securities has been increased from
A- to AAA from January 2009. Besides, from November the Eurosystem accepted as collateral
negotiable debt instruments denominated in US dollars, GB pounds or yen but issued within the
European Economic Area.
The exceptional measures adopted in the last quarter of 2008 on one hand probably avoided
systemic crises and deposit run; on the other hand, they witness a situation of extreme uncertainty
within the money market, which contributed to increase the liquidity demand from the Eurosystem.
Once adopted the open market operations without quantitative limits, the liquidity supplied through
such operations has almost doubled. Longer-term refinancing operations had a more than
proportional growth, while, at the same time, deposits at the Eurosystem significantly increased.
Moreover, the EONIA rate reached a level constantly below the main refinancing operations rate
(Graph 4).
18
Graph 4. The liquidity supply through open market operations and use of standing facilities (€ billion)
Source: European Central Bank (2009a), p. 101.
Last, the non-conventional monetary policy measures adopted since October 8th determined, among
others, a huge expansion of the balance of the central banks which are part of the Eurosystem, as
well as a redistribution of the most significant assets and liabilities31. The fact that banks preferred
to deal with central banks rather than other market participants during the turmoil had important
implications in order to avoid systemic effects for the crisis. However, such a market equilibrium
with a major role of central banks in the interbank market cannot be considered efficient in the
medium and long term and must be rethought.
The fifth and last phase of the Eurosystem’s monetary policy action started on May 7th 2009 and is
characterized by signals that show more normal liquidity conditions. In this date, the ECB board
decided to reduce again the rates of main refinancing operations and on marginal lending facilities,
while it maintained the rate on deposit facilities at 0.25%. Furthermore, the ECB chose to directly
buy up to 60 euro billion of covered bonds, similarly to what agreed by the Fed and the Bank of
England, in order to facilitate the credit flows to the economic system. Thus, for the first time the
European Central Bank decided not to operate through the banking channel, but wanted to act
directly on the markets, contributing to sustain a market significantly affected by the crisis.
However, the decision to directly buy covered bonds, after several weeks of debates within the
ECB, has been severely criticized because these bonds are largely issued in Germany, but have no
31
During the 2008 the consolidated balance sheet of the Eurosystem’s central banks increased of about 60%; in the
same year, the balance sheet of the Federal Reserve and the Bank of England more than doubled. In April 2009 the
Eurosystem’s balance sheet size was 1,51 euro trillion (16% of the euro area GDP); in the same period, the Fed balance
sheet was equal to 14% of US GDP. See Banca d’Italia (2009) and Papademos (2009).
19
market in many other countries within the area; this empirical evidence could, other thing being
equal, generate asymmetrical effects on credit access opportunities within the euro area.
5.
The e-MID case and the interbank market within the euro area
In order to analyze the reasons of the anomalous functioning of the interbank markets during the
2007 – 2009 crisis, it is useful to focus on their structural and organizational features, as well as on
the typology of contracts traded in these markets. A first important distinction to perform is
between markets in which contracts are guaranteed by liquid assets and negotiations without any
guarantee. Coherently, interbank markets are distinguished between secured and unsecured
markets.
Interbank markets worldwide are characterized for an undefined structure. Moreover, they are
fragmented in nature. For direct loans, which account for the vast majority of lending volume, the
amount and the interest rate on each loan are agreed on a one-to-one basis between borrowing and
lending institutions. Other banks do not have access to the same terms, and do not even know that
the loan took place. Although quotes are sometimes displayed on screens, these are merely
indicative. Trades are largely bilateral or undertaken via voice brokers. The vast majority of
transactions take place on over-the-counter markets, without a specific trading regulation. Under the
technical standpoint, negotiations are mostly performed through telephone, while the diffusion of
quotations and information is largely done through information providers – basically Bloomberg or
Reuters - which publish the quotations of interbank contracts for different maturities. This market
organization, however, has a significant limit due to the fact that quotations are only indicative,
while the actual market interest rates could considerably vary, also according to the counterparties
involved in transactions.
Beside over-the-counter interbank markets on telephonic basis, in Italy since the late 80s an
electronic market for liquidity has been developed. This market, which is unique for several
characteristics, is called “e-MID”. The key operative features of the e-MID can be summarized as
follows32:
• it is a market based on a dedicated electronic platform, in which banks can publish the
liquidity amounts that want to lend or borrow, indicating different maturities and interest
rates;
32
For a deeper analysis of the e-MID see Vento (2005).
20
• the e-MID is a multicurrency interbank market, where financial institutions can negotiate
short term funds in euros, US dollars, GB pounds and Polish zlotys (however, the vast
majority of negotiations take place in euros);
• the market makes possible to negotiate standardized interbank deposits having different
maturities, which vary from overnight to one year;
• the e-MID offers an automatic settlement facility for contracts in euros at European level;
• market participants are committed to fulfill a set of common rules created by the company
that manages the market;
• the e-MID is a quote-driven market, in which once the quotations are entered in the system,
contracts can be simply closed with the counterparty’s acceptance;
• the Bank of Italy, according to the article 79 of the Italian Finance Law (d.lgs. n. 58/98),
performs a continuous supervision on the market, contributing to determine safer operative
situations compared to bilateral telephonic deals;
• beside the unsecured interbank market, the e-MID company, since 2000, manages an
overnight indexed swaps market, called e-MIDER, at which 113 European and US banks
participate, of which 28 central banks as observers.
The success of the e-MID market up to the crisis has been witnessed by the increasing number of
market participants as well as by the traded volume over time. In May 2009, 244 banks from 29
European countries and from United States used to participate at the market; among these banks
there were 30 central banks (as observers of the market) an 2 ministries of finance. Before the Great
Financial Crisis, the ECB estimated that the 17% of interbank transactions within the euro area used
to transit through the e-MID platform33. Since August 2007, however, the overall interbank trading
decreased at global level, also affecting the Italian electronic market more than proportionally. The
average daily volumes on e-MID passed from 24.2 euro billion in 2006 to 22.4 billion in 2007 and
dropped to 14 billion in 2008 34. Nevertheless, the recent difficulties in the functioning of the e-MID
are demonstrated also by other indicators. In the last two years the activity of foreign operators
decreased, the concentration of negotiations on overnight segment strongly increased as well as
there was an enlargement in bid-ask spreads 35. The trends registered in the e-MID appear much
more significant than the tendencies analyzed in the OTC unsecured interbank market in the euro
area. A usual survey conducted by the European Central Bank (2009b) on a panel of 85 large banks
based in the euro area highlighted that in 2008 the volumes’ reduction and the concentration on
33
See European Central Bank (2007).
See Banca d’Italia (2009).
35
The Banca d’Italia (2008 and 2009) shows how the bid-ask spread on e-MID passed from one basis point to six basis
points in the last quarter of 2007. At the same time, the traded volumes on overnight maturity increased above 90% in
2007 and 2008.
34
21
very short-term maturity affected the overall euro area interbank market, but with a lower intensity
compared to the e-MID (Graph 5).
Graph 5. Daily turnover in unsecured interbank borrowing (cash borrowing volume in 2002=100)
Source: European Central Bank (2009b), p.13.
As mentioned above, the drop in traded volumes in the interbank market and the increase of
volatility and concentration on short term negotiations do not depend on an increase in counterparty
risk premia only. Thus, it is useful to interpret the reasons why the spread between Euribor and
Eurepo rates, usually close to 10 basis points, increased to about 70 basis points since the beginning
of the crisis, and jumped above 200 basis points just after the Lehman Brothers default, in October
2008 (Graph 6).
Graph 6. Euribor and Eurepo rates during the crisis
Source: own estimation on Bloomberg data.
22
A first interpretation of these data could induce to believe that the market participants required a
higher return for unsecured interbank loans because, in the framework of a financial turmoil the
default probabilities of counterparties increased. However, such interpretation does not appear
completely supported by the evolution of the risk premia on the securities issued by the banks.
Comparing the spreads between Euribor and Eurepo with the spreads on credit default swaps (CDS)
for a panel of European banks, Eisenschmidt and Tapking (2009) conclude that there are other
components, different from credit risk, which determine the increase in unsecured interbank rates.
The factors that, beside credit risk, seem to have affected interbank interest rates during the turmoil
are the so-called “liquidity hoarding” (banks accumulate liquidity well above their current and
expected needs, just to face potential liquidity shortages in case of further reduction in market
liquidity). In this framework, treasurers preferred to accumulate significant volumes of liquidity,
and subsequently decided to deposit such liquidity at the national central banks, rather than lending
it on interbank market, obtaining an interest which usually represent the lowest rate in the official
corridor.
On the other hand, banks reduced their participation in interbank markets also being afraid that, in a
context of general uncertainty and tensions on the markets, the raise of funds on such a market
could be interpreted as a dangerous signal of liquidity shortage, which could generate further
funding difficulties (so-called “stigma effect”). Last, despite the lack of official data, other factors such as conterparties’ dimensions, regulatory capital adequacy, rating and country of origin –
seemed to have a role in the decision of dealing. Particularly, the smallest banks within the euro
area seem to prefer to manage their financial disequilibrium with domestic counterparties, for which
they have more information and are able to perform a more careful counterparty risk analysis,
whereas biggest banks – which are more capitalized and often have a better rating – mostly deal
with international counterparties, having similar features.
The empirical evidence about CDS spreads proposed by Eisenschmidt and Tapking (2009) for the
euro area seem not completely consistent with a similar analysis we performed on Italian market. In
fact, comparing the one year Euribor-Eurepo spread with the average one year CDS spreads for a
panel of six top Italian banks (of which two are also part of the Euribor panel), we obtain that up to
the Lehman’s default the trend of the Italian sample is very similar to the European one; however,
since October 2008 onwards, the latter spread is greater than the former (Graph 7).
This evidence for the Italian banks – which is not in line with the trends at European level that can
justify liquidity hoarding behaviors - can be interpreted as an indication that in the most acute
phases of the crisis the risk perception on some specific banks was extremely high, well above the
23
average of European Banks. Thus, it can be affirmed that the Lehman’s default and the subsequent
turmoil affected various banks with different intensity.
Graph 7. Euribor-Eurepo spread and Average CDS spread on a panel of Italian banks
Source: own estimation on Bloomberg data.
The above-mentioned phenomena concerning interbank markets, absolutely peculiar of the recent
financial crisis, influenced both transactions on traditional over-the-counter markets and the e-MID
deals. Nevertheless, negotiations on e-MID are characterized for an higher transparency level
compared to bilateral telephone-based markets, because in the e-MID case all the bid and ask
volumes are known by the other participants. Thus, this evidence can be considered as one of the
most significant factor that determined a progressive depart from the e-MID during the crisis,
pushing the operators towards collateralized operations or bilateral and less transparent transactions.
Since September 2008 the volumes on interbank market registered a further reduction36 and, at the
same time, the functions of the market have been performed by the Eurosystem, which arranged
special monetary policy operations in order to avoid the complete collapse of the market.
In this framework, also the company that manages the e-MID market decided to offer services
which fit closer to the need of market participants. In order to tackle the volumes drop, since the end
of November 2008 the e-MID made possible to negotiate interbank deposit through the so-called
“depo auction” facility. Such function let the participants to request specific quotations from a
number of counterparties between one and five. Alternatively, the banks can propose directly to a
counterparty an amount and a rate, and the counterparty can simply accept the proposal, can
formulate a new proposal or can refuse the transaction.
36
See par. 6.
24
However, a more significant innovation has been registered since February 2009, when the Bank of
Italy started – together with the company that manages the e-MID market, the Italian banking
association and the Italian association of banking treasures – a new initiative called “MIC”
(Collateralized Interbank Market) addressed to create a new interbank segment, guaranteed by
collateral, in which is possible to trade interbank funds having maturity between one week and six
months.
6.
Which perspectives for the interbank market and liquidity distribution?
A major lesson of the recent financial crisis is that the ability of banks to withstand liquidity shocks
and to provide lending to one another depends on the functioning of interbank lending market. In
this section we want to investigate the impact of the financial crisis on Italian money market in
order to analyze the general impact on interbank lending patterns and interbank lending networks in
the future.
To this aim, we use data on transactions on the Italian interbank money market, e-MID. As above
mentioned, this market is unique in the euro area in being screen-based and fully electronic: the
information about the rates and the trades is made public.
The e-MID is market without collateral where banks normally exchange short-term funds in a
transparent manner 37: in this context, banks can exercise a continuous peer monitoring activity. Its
transactions are concentrated on overnight deposits denominated in euro, which account for 90% of
the total volumes traded. Starting from February 2009, the MIC market (Mercato Interbancario
Collateralizzato) operates with the aim of further developing the interbank market using the e-MID
platform also for collateralized exchanges.
Our dataset includes most overnight trades made through e-MID between January 2005 and June
2009. Trading in the e-MID starts at 8 a.m. and ends up at 6 p.m.38. During our sample period
overnight loans account for over 75 percent of the total amount lent (casual evidence suggests that
this is a common feature of most interbank markets).
After a considerably growth in recent years where it was fully used by major European banks (non
Italian banks account for about 43% of daily trades as of June 2008) the data confirms that the
interbank market was severely affected by the turmoil. A strong decline in the overall electronically
traded market volume (right axis) and number of contracts (left axis) could be observed, most
37
Every trade proposal posted on the system is transparent because the identity of the proponent is disclosed to all
members.
38
In particular, in the major electronic marketplace for interbank loans in the euro area deals between Italian banks
matures at 9 a.m. (next day): at this time previous day trades are settled in real time, as the borrowing bank has to repay
the amount due through a Target payment. Deals involving (at least) a foreign bank mature by noon (next day).
25
evidently since November 2007 (Graph 8) 39. In the same reference period, a large number of
intermediaries were active with less intensity (Graph 9).
Graph 8. Monthly volumes and number of contracts for unsecured deposits traded on the e MID
12.000
800.000
total volume
deal
700.000
10.000
8.000
500.000
6.000
400.000
300.000
4.000
Volume (mln euro)
Number of deal
600.000
200.000
2.000
100.000
4/09
1/09
10/08
7/08
4/08
1/08
10/07
7/07
4/07
1/07
10/06
7/06
4/06
1/06
10/05
7/05
4/05
0
1/05
0
Source: own estimation on e-MID data.
Graph 9. Average volume for single contract on e MID market
80,00
Average volume for single contract
Volume for contract
70,00
60,00
50,00
40,00
30,00
20,00
5/09
1/09
9/08
5/08
1/08
9/07
5/07
1/07
9/06
5/06
1/06
9/05
5/05
0,00
1/05
10,00
Source: own estimation on e-MID data.
The analysis of the intraday volumes distribution (Graph 8) shows the permanence of the liquidity
trading during the day, although it is possible to verify a strong activity concentration during the
39
The decline during the 2007 is lower considering that the effects of the financial crisis on the money markets have
been revealing beginning from August of 2007
26
first hours of the morning and a physiological reduction between the 13:30 and the 14:30, and at the
end of the day. The introduction of Express II increased overall transactions volume on the e-Mid,
particularly at the beginning of the day amplifying the so-called "morning effect": about 45% of the
liquidity is exchanged during the first two hours of the morning (8:30- 10:30). This is due both to
the adjustment of unbalances from transactions not regulated in the nighttime cycle and to the
European Banking Federation deadline for posting lending quotes at the Euribor rate.
At the same time, the overall trading pattern throughout a business day basically retained its Ushaped form found by previous literature, with a peak in trading activity both in the early morning
(25% of overall overnight trading volumes from 9 to 10 o’clock) and in the afternoon even if less
marked (only 13% from 4 to 5 o’clock)40. The U-shape of overnight volumes also reveals a slight
delay in trading activity in the afternoon (Table 6). In an environment of higher uncertainty about
current and prospective aggregate liquidity conditions41, banks do not seem to prefer to wait until
relevant information, such as an announcement by the ECB whether it will conduct a fine tuning
operation, is available.
Table. 6. Distribution of overnight intraday trading volumes on e MID from July 2007 to June 2009
Trading
Time
8:00 - 9:00
9:00 - 10:00
10:00 – 11:00
11:00 – 12:00
12:00 – 13:00
13:00 – 14:00
14:00 – 15:00
15:00 – 16:00
16:00 – 17:00
17:00 – 18:00
Intraday ON
trading volumes
3%
25%
14%
9%
7%
5%
8%
11%
13%
5%
Cumulative trading
volumes
3%
28%
42%
51%
58%
64%
71%
83%
95%
100%
Source: own estimation on e_MID data
At least during healthy financial periods, little explicit risk pricing takes place in the overnight
segment. Providers of funds have the ability to “get out in time” when they see the borrowing bank
having problems. This may well be rational behavior in an environment where the vast majority of
financial institutions are in sound condition and information is costly to discover. Thus, we may
never observe risk premia for the riskiest banks because they are simply unable to borrow in the
market.
40
We divided the day into 9 hourly time bands: from 9 a.m. to 6 p.m.
In the case of unsecured lending, the creditworthiness of the borrower does not considerably influence the overnight
trading volume.
41
27
The information collected on provide evidence of borrowers switching from a transparent electronic
dealership market to more opaque over-the-counter bilateral market. The decline in e-MID’s
volume stands in contrast to a weak drop in Italian interbank trading volumes. It seems that banks
prefer borrowing in a less transparent environment in order to avoid being openly seen in the
market on the borrowing side.
As the empirical analysis shown in our paper suggests, it is plausible that market discipline (or
adverse-selection-based process) in the e-MID operated through rationing, perhaps to a greater
extent than through a price mechanism. It brought out an increasing concentration on volume
(Graph 10) as underlined by the Herfindahl index, estimated on bid and ask volume of Italian banks
compared to the overall volume on e-MID.
Graph 10. Concentration of volumes on e-MID from 31 December 2007 to 31 July 2009
6,0%
Herfindahl Index (HFI)
5,0%
4,0%
3,0%
2,0%
1,0%
01/07/2009
01/06/2009
01/05/2009
01/04/2009
01/03/2009
01/02/2009
01/01/2009
01/12/2008
01/11/2008
01/10/2008
01/09/2008
01/08/2008
01/07/2008
01/06/2008
01/05/2008
01/04/2008
01/03/2008
01/02/2008
01/01/2008
01/12/2007
0,0%
Source: own estimation on e-MID data.
To foster a recovery in trading on the interbank circuits and a greater diversification of contract
maturities, the Banca d’Italia, together with e-MID SIM Spa and the Italian Banking Association
(ABI) has introduced a temporary guarantee scheme, the Collateralized Interbank Market (MIC).
Inside the MIC, which originally had to remain active up to the end of 2009, but it has been
prolonged for one more year, operate Italian banks42 (no more than one for each banking group) and
EU banks (only after an agreement with the national central banks of the country of the bank that
participates)43 which satisfy a limited set of conditions equal for all participants.
42
They may operate within the limit assigned by Banca d’Italia based on the assessment of the collateral conferred to
the scheme.
43
The banks that can participate to the collateralized market are only those with a registered office on Italy, provided
that they have agreed to the Automatic Settlement Service in Target2. EU banks with remote access to e-MID or
through an Italian branch may participate based on the same requirements, subject to an understanding between their
National Central Bank and Bank of Italy.
28
The trading on MIC is characterized for a specific guarantee of the Bank of Italy on the obligations
of market participants, for an active role of the Italian central bank on the custody, administration
and evaluation of collateral, as well as for the complete anonymity of counterparties. Nevertheless,
the Bank of Italy supplies its guarantee against a wide range of collateral, having a value not below
€ 5 million44. Limits on MIC have been fixed in order to facilitate large market participation, but
also to limit the risk concentration. The eligible assets in the MIC are all those accepted in the
monetary policy operations by the Eurosystem (which must be at least 10% of the collateral),
securities guarantees by the governments of Italy and other European states, financial instruments
that can be used for borrowing securities from the Bank of Italy (having rating below BBB- or
Baa3), and other assets of lower quality, accepted by the Bank of Italy on discretionary basis45.
Besides the above mentioned assets, also the bank loans towards non financial companies, public
entities and international institutions based within the EU can be used as collateral in the MIC.
These bank loans, however, must have a minimum rating equal to BBB-/Baa3, or a default
probability below 0.40% for those banks which adopt IRB systems already validated from the
Supervision Department of the Bank of Italy. In this way, also less liquid assets, or securities which
are not eligible as collateral for Eurosystem’s monetary policy operations can contribute to create
liquidity. All the assets have different haircuts, according to the issuer category, the typology of
instruments, the maturity, the currency and, for loans, the typology of interest rate. With regards to
the costs that may arise from the insolvency of one of the counterparties, the guarantee scheme
designed by the Bank of Italy and the company that manages the market is based on a mutual
distribution of such costs – with a maximum of 10% of the collateral deposited by any market
participant – in case the collateral of the insolvent bank is not sufficient. In the unlikely event that
also the mutual guarantee is not enough, there is a direct guarantee offered by the Bank of Italy.
Thanks to the contribution of MIC, duration weighted volumes on e-MID fixed term maturities are
recovering from lows (Graph 11).
In the idea of the Bank of Italy and of the company that manages the e-MID, the MIC makes
possible to eliminate those credit, liquidity and reputational risks, which determined the reduction
of the market volumes on e-MID between the end of 2007 and the 2008. Particularly, the financial
guarantees cancel the counterparty and liquidity risks, while the fact that the interbank market is
anonymous lets the banks which necessitate funds not to inform other intermediaries of their
financial needs, avoiding the so-called “stigma effect”. Last, the guarantee of the Bank of Italy
44
Particularly, the Bank of Italy established that the overall net exposure for each participant in the MIC cannot exceed
50% of the consolidated prudential capital at June 30 2008 and, however, € 5 billion.
45
The eligible assets can be denominated in euro or other main currencies and does not have to have a nominal value
below € 500,000.
29
determines another important advantage, which is the lower regulatory capital need compared to the
traditional unsecured interbank loans.
Graph 11. Outstanding volume (million of euro) and average maturities (days) trend on MIC
Volume (mln €)
70
average duration (days)
60
5.000
50
4.000
40
3.000
30
2.000
Volume (mln €)
Weighted average duration
6.000
20
1.000
10
0
07/08/2009
24/07/2009
10/07/2009
26/06/2009
12/06/2009
29/05/2009
15/05/2009
01/05/2009
17/04/2009
03/04/2009
20/03/2009
06/03/2009
20/02/2009
06/02/2009
0
Source: own estimation on e-MID data.
As underlined by Saccomanni (2009), in the near future the new market could be used as a
reference for setting up a similar scheme at a pan-European level.
7.
Conclusions
The Great Financial Crisis, among other consequences, had peculiar and unexpected effects on the
functioning of the interbank market. According to the analysis hereby done, the fall in traded
volumes is mostly depending on a lack of confidence of banks’ treasures towards other banks,
perceived as too risky for operations not collateralized or for maturities exceeding overnight. In the
most critical stage of the crisis, subsequently the Lehman Brothers default, banks worldwide
decided to hoard liquidity – suffering a significant opportunity cost – being afraid of a worsening in
the market liquidity risk, which could generate higher funding costs as well as a further scarcity of
funds. At the same, the liquidity accumulation was addressed to avoid to send signals to the market,
which could be interpreted as a warning sign of liquidity tension, potentially followed by a default.
Therefore, these empirical evidences induce to affirm that the current unsecured interbank market
segmentation within the euro area - where the e-MID electronic platform coexists with over-thecounter bilateral exchanges and negotiations closed through voice brokers -
is functional to
different needs of the market participants. Despite the e-MID has clear advantages in trading
efficiency and in facilitating the transmission of monetary policy impulse, the other segments of the
30
OTC interbank market make possible to better deal in undisclosed conditions, whenever the market
participants do not intend to reveal their actual liquidity needs. Since February 2009, in order to
reacquire market shares lost during the crisis, such a facility has been offered by the e-MID
platform too.
On the other hand, the crisis demonstrated how the systematic underestimation of credit risk, typical
of the financial system up to the summer 2007, involved the interbank market too, in which the risk
premiums were virtually not priced and not coherent with the concrete counterparty risk. The
current differences between the unsecured interbank rates and the collateralized ones seem now
more consistent with the counterparty risk, and consequently we may assume that the spreads
between secured and unsecured rates will remain on levels well above those usually reached before
the crisis.
Furthermore, as long as the treasurers are performing an analysis of counterparty risk on interbank
market, it is reasonable to expect an improvement of the models adopted by banks in order to assess
the probability of default of financial institutions. It is also likely that the money market will be able
to take from the crisis the right stimulus in order to ameliorate the techniques and the procedures
for a stronger analysis of liquidity risk and counterparty risk in the interbank transactions. The
Eurosystem and the supervisory authorities must have a role in incentivizing the European banking
industry to adopt more adequate methodologies for the assessment of market liquidity risk, while, at
the same time, the authorities can promote the implementation of clearing and settlement systems
more respondent to the needs of the banks in the euro area.
Besides, it is reasonable to believe that the current counterparties’ assessment process within the
interbank market, according to the counterparties’ dimensions, capital adequacy and ratings, could
become a structural feature of money and interbank markets. In such a framework, the smallest
banks seem to prefer to manage their financial disequilibrium with domestic counterparties, for
which they have more information and are able to perform a more careful counterparty risk
analysis, whereas biggest banks – which are more capitalized and often have a better rating –
mostly deal with international counterparties, having similar features.
Also the overall reduction of the volumes on interbank market does not appear a short-term
phenomenon. This gives the impression to depend on the current reduction in credit supply and in
the volumes intermediated by banks, but also to be linked with the fact that, at global level, banks
are abandoning business models based on a large recourse to the interbank funding in order to boost
their capability to supply credits. In this context, also the orientations coming from the supervisory
authorities are pushing the banking industry towards a closer relationship between the retail funding
capability and the growth of the loan portfolios.
31
Moreover, the Great Financial Crisis established a structural divergence between the official
monetary policy rates and the money market rates. This phenomenon does not seem to depend on
short-term tensions and generates serious doubts about the capability of central banks to address in
the next years the yield curve by using the traditional monetary policy instruments only.
In the above-illustrated framework, the new Italian Interbank Collateralized Market (MIC) can
represent an operative solutions that, besides the traditional e-MID and the other O-t-C market
segments, may offer to the treasuries a viable alternative to the operations directly performed with
the Eurosystem. The presence of the MIC makes possible to have a perception of the evolution of
interest rates for different money market maturities and the fact that the collateral deposited by the
adherent banks largely exceeds the current traded volumes may be a signal of a further development
of the market in the future. Also in the perspective of the central bank that supports the MIC,
provided that it does not have a role of market maker, the risks assumed are significantly inferior
compared a massive liquidity supply through the main refinancing operations, whereas the
contribution to the monetary policy impulse transmission may be considerable. For all these
reasons, the Eurosystem is now reflecting about the opportunity to promote pan-European platforms
for the exchange of collateralized interbank funds, so contributing to design a European money
market in which bilateral transactions, voice brokers and electronic platforms coexist, responding to
different financial needs.
32
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