Distress in Money Markets during the Global Financial Crisis: An Analysis of Co-Movement and Transmission

By Ito, Takayasu | IUP Journal of Applied Finance, January 2013 | Go to article overview

Distress in Money Markets during the Global Financial Crisis: An Analysis of Co-Movement and Transmission


Ito, Takayasu, IUP Journal of Applied Finance


(ProQuest: ... denotes formulae omitted.)

Introduction

As Hegde and Paliwal (2011) indicate, the models of financial crisis and contagion predict that an economic emergency becomes a crisis of market liquidity in the presence of borrowing constraints, information asymmetry and risk aversion. During the global financial crisis, originating from the US subprime loan problem, it was not surprising to note that distress disseminated across global money markets, amplifying both default and systemic risks. This mechanism could operate through direct linkages among global financial markets. Uncertainty over the mortgage exposure of counterparties and inability to value their respective assets were particularly enhanced after the subsidiaries of BNP Paribas announced the suspension of liquidation of asset on August 9, 2007. Taylor and Williams (2009) point out that the traders in New York City (NYC), London, and other financial centers around the world faced a dramatic change in the conditions of the money markets from that date onward.

The impact of this was felt, particularly in the major financial markets, in the form of widening of the London Interbank Offered Rate - Overnight Indexed Swap (LIBOR-OIS) spreads, which in turn led to increased funding costs in the growing default risk. The collapse of Lehman Brothers saw a peak in distress in the global money markets, leading to a further widening of these spreads.

LIBOR is the reference rate at which banks indicate they lend to other banks for a specified term loan. The OIS rate is the rate on a derivative contract on the overnight rate and serves as a measure of the market's expectation of the overnight funds rate over the term of the contract. There is very little default risk in the OIS market because there is no exchange of principal amounts. Funds are exchanged only at the maturity of the contract when one party pays the net interest obligation to the other. Sengupta and Tam (2008) maintain that the LIBOR-OIS spread is a closely watched barometer of distress in money markets, most seriously impaired by the events of 2007 and 2008.

This paper investigates the co-movement and transmission of distress across money markets during the global financial crisis by analyzing LIBOR-OIS spreads with a focus on the US, Eurozone, UK and Japan. It makes two main contributions. Firstly, it investigates the asymmetrical impact of global financial crisis on LIBOR-OIS spreads by dividing the sample period into two, because it is important to assess the impact of the global financial crisis across these phases. As the severity of the crisis varied from one period to another, its asymmetric impact on distress in money markets needs to be considered. In other words, we analyze whether the co-movement and transmission of distress in money markets of the US, Eurozone, UK and Japan differ, depending on the period of the study.

We regard the beginning of the global financial crisis as August 9, 2007 when the subsidiaries of BNP Paribas announced the suspension of the liquidation of assets because it was difficult to obtain fair values for Asset-Backed Securities (ABS) related assets under the market pressure. The second stage commenced on September 15, 2008 when Lehman Brothers went bankrupt. Imakubo et al. (2008) and Ji and In (2010) treat the global financial crisis as occurring over a single period. However, our results show that the co-movement and transmission of LIBOR- OIS spreads depend on the sample period.

The distress moved synchronously in the major financial markets such as the US, Eurozone, UK and Japan, before Lehman shock, through the process of global transmission. However, such a coordination was found only between UK and Eurozone after the bankruptcy of Lehman Brothers. The distress became more of a regional issue within each major financial market. The results of this study implied that the problem of financial system stemming from the sovereign deficit crisis would be serious in Europe, particularly in Eurozone. …

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