Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis

1
Precautionary Hoarding of Liquidity and
Inter-Bank Markets Evidence from the Sub-prime
Crisis

• Ouarda Merrouche
• Bank of England
• (with Viral V. Acharya, London Business School)
• PRELIMINARY-COMMENTS WELCOME
• 5 September 2008

FS252347
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Importance of money markets

• Money markets lubricate credit flows in the
  economy
• Well-functioning inter-bank markets ensure that
  liquidity travels to the place where it is needed
  the most
• Central Banks, through their monetary policy
  operations (reserve requirements, averaging, and
  corridors) can target interest rates
• Conversely, a freeze in the money markets can
• Impair or stagnate lending to the real sector
• Force Central Banks to undertake massive
  liquidity operations, possibly undertaking credit
  risk in the process
• This paper
• View of money markets from the lens of
  precautionary liquidity

3
Liquidity hoarding and the freeze

• FT 12 August 2007 Scramble for cash reflects
  fears for system
• FT 26 March 2008 Hoarding by banks stokes fear
  over crisis
• FT 19 May 2008 Loans to banks limited despite
  market thawing
• It is unclear to what extent hoarding of
  liquidity reflects a genuine need to stem rising
  losses, and to what extent it reflects an
  extremely precautionary behavior driven by high
  uncertainty
• Marco Annunziata, chief economist at
  UniCredit bank

4
Questions

• What is the impact of precautionary liquidity
  hoardings of banks on inter-bank markets?
• The issue of reverse causation
• Can one establish that liquidity hoardings are
  indeed precautionary in nature?
• Does the variability in inter-bank rates induced
  by liquidity hoardings matter?
• What are the policy implications for Central
  Banks?

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Setting

• Sterling money markets
• Overnight and 3-month secured and unsecured
• Rates as well as volumes
• Reserve balances of large, settlement banks
• A good measure of daily liquidity
• Can add collateral to get a measure of total
  liquidity
• Payments and settlements activity
• CHAPS
• Bank-level distress and funding liquidity stress
• Bank-level household and corporate lending rates,
  volumes

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Tiered Structure of the Markets

• 400 banks active in the UK
• 15 direct participants in the large-value payment
  system (CHAPS) i.e. settlement banks
• Tiered structure reflected in money market
  activities
• Top 4 first-tier clearers intermediate liquidity
• Horizontal flow at first-tier Vertical flow
  between second-tier and first-tier
• Limited horizontal flow of liquidity at the
  second tier

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Monetary Policy Framework

• No requirement to hold reserves (voluntary) i.e.
  choice of reserves targets (limited by a ceiling)
• 1 Month maintenance period
• Remuneration at policy rate
• Zero percent on average reserves above 101 of
  target. Equivalent penalty for average reserves
  below 99
• Liquidity provided by weekly OMO (Thursdays)

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Adjustments during the Crisis

• September 13th-18th 2007 OMOs 25 of reserves
  target additional liquidity injected in OMO
• September 19th 3 months actions against wider
  range of collateral
• October 4th 2007 Widening of bands around target
  from 1 to 30 percent
• April 21st 2008 Special Liquidity Scheme
• May 8th 2008 Double reserves Target Ceiling

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Results - I

• Regime shift in aggregate bank liquidity levels
• Reserve targets have risen (August 07, March
  08)
• Also levels of daily and total liquidity
• Relationship between aggregate liquidity and
  rates has ALSO undergone a structural shift
• Pre-crisis Rise in liquidity caused rates to be
  lower
• Traditional money-market arbitrage argument
• Post-crisis Rise in liquidity caused rates to
  rise
• Private benefit of liquidity above the policy
  rate
• Effect on secured as well as unsecured rates
• Unlikely due to counterparty risk on transactions

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Theory of financial constraints

• Normal times unconstrained banks
• Reserves set primarily to meet regulatory
  requirements and to some extent settlement
  uncertainty
• Private benefit of liquidity relatively low
• If reserves increase, banks release them
  pushing rates down towards the policy rate
• Crisis times banks are funding-constrained
• Banks build up reserves for precautionary reasons
  
• Other than settlement uncertainty or more
  responsively so
• Private benefit of liquidity relatively high
• If reserves increase, banks release them ONLY
  IF return on liquidity exceeds the private
  benefit

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Revised arbitrage condition

• Inter-bank rate Policy rate Liquidity premium
• Implications
• Should apply to secured as well as unsecured as
  liquidity premium is about opportunity costs, not
  counterparty risk
• Liquidity premium induces an additional source of
  uncertainty in spread of inter-bank to policy
  rate
• Unlikely due to differences in collateral
• Contagion
• Likely to affect ALL borrowing banks
• Liquidity hoarding entails withdrawals elsewhere
  (other banks, households, corporations)

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Results - II

• Bank-level liquidity hoardings appear indeed to
  be precautionary in nature
• Larger for banks that had
• Greater losses
• Larger equity price decline
• Greater reliance on wholesale funding
• There is evidence of contagion
• Bank-level borrowing rates increase with
  liquidity hoardings of other banks during the
  crisis
• Bank-level lending rates rise in response to
  individual inter-bank rate of borrowing

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Liquidity measures

• Total Liquidity Overnight Liquidity Intraday
  Collateral
• Overnight Liquidity Reserves Accounts Balance
  at 5 am
• Intraday Collateral Maximum Collateral posted
  to obtain intraday credit from central bank
• NOTE In bank-level regressions, we employ these
  measures, scaled by subtracting mean and dividing
  by standard deviation so as to focus on abnormal
  variations

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Total liquidity
15
Settlement bank Reserves
September 11th 2007
March 13th 2008
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OMO Bids
17
Policy Rate
18
Bai-Perron tests
Total Liquidity
Overnight Liquidity
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Regime shift in bank reserves

• FT 9 April 2008 UK banks seek higher borrowing
  facilities
• FT 10 April 2008 UK banks seek more BoE
  borrowing
• UK banks asked to increase sharply the reserves
  they hold on deposit at the Bank this month to
  the highest ever level amid concerns that the
  instability of the banking system could suddenly
  leave them desperate for cash. They fear another
  bank crisis - akin to the collapse of US
  investment bank Bear Stearns - could see the
  market seize up.
• Banks have asked to keep total reserves of
  23.54bn on deposit that they can borrow to meet
  short-term financing needs if they cannot borrow
  in the inter-bank market. This is up from the
  nearly 20bn they had on deposit until yesterday.
  This is money the banks keep on deposit at the
  Bank, earning interest, but that they can access
  when the cost of borrowing from other banks
  becomes too high.

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Money market rates

• Overnight Secured Rate Gilt Repo Rate
• Overnight Unsecured Rate SONIA Rate
• 3-Months Secured Gilt Repo Rate
• 3-Months Unsecured 3-Months Libor
• 3-Months Unsecured volume CHAPS 3-months
  volume, extracted using Furfine (1998) algorithm

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Money market rates and volumes
Difference Post August 9th Pre August 9th
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Spreads to policy rate
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Liquidity and secured spread
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Liquidity and 3-month LIBOR-OIS
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Identification problem

• Econometric problem
• Liquidity responds to uncertainty and rate
  expectations
• Rates may also rise due to uncertainty
• Effect of liquidity on rates may thus be due to
  endogeneity or omitted variable bias, rather than
  causal
• Solutions
• Examine overnight GILT secured rates
• Correct for correlated shocks through SURE
• Apply instrumental variable approach to correct
  endogeneity biases
• We adopt all three

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Control Variables

• OMO days
• Maintenance days fixed effects
• Adjustments to Monetary Policy Framework (1)
  widening of bands (2) higher reserves ceiling
  liquidity scheme
• (Uncovered OMO on last week of June 2007)

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Liquidity and rates
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Instrument

• Lagged level of aggregate payment and settlement
  activity (value, volume)
• Rationale
• High settlement activity days are accompanied by
  higher liquidity reserves
• Buffer against greater reserves uncertainty in
  future
• If liquidity reserves are imperfectly adjusted on
  a day to day basis, there would be residual
  effect in liquidity reserves of past settlement
  activity
• Ultimately, an empirical question
• Settlement activity driven by calendar-day
  effects, and thus uncorrelated over time

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Payment and settlement activity

• CHAPS payment activity value and volume
• Net of overnight inter-bank loans, in logarithm
  and in bank-level regressions, scaled by
  subtracting mean and dividing by standard
  deviation
• High value for same volume Larger transactions,
  greater risk
• High volume for same value Smaller
  transactions, lower risk

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CHAPS payment activity value
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CHAPS Payment activity volume
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Liquidity and rates (second-stage)
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Economic significance

• Liquidity effect
• Pre-Crisis a 10 per cent increase in overnight
  liquidity causes a 6.6 basis points decline in
  overnight secured spread
• During Crisis a 1.1 basis points rise in
  overnight secured spread
• During Crisis a 24 basis points rise in 3-M
  Libor-OIS spread

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Liquidity and payments (first-stage)
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Payments and calendar effects
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Precautionary nature of liquidity

• Approach 1 Assess contribution to structural
  break in liquidity by Loss Ratio and Retail Ratio
  
• Approach 2 Split sample of banks into two groups
  to allow heterogeneous reaction to aggregate
  fluctuations in payment activity
• Higher and lower than median loss ratio to total
  assets
• Higher and lower than median retail to inter-bank
  deposit ratio
• Higher and lower than median bank equity price
  variation from 2006

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Results I
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Result II
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Bank characteristics

• Losses Disclosed relative to Total Assets
• Source Bloomberg
• Period January 2007-June 2008
• Initial Retail over Inter-bank Deposits Ratio
• Source Interim reports as of June 2007
• Period Immediate Pre-Crisis Level

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Economic significance

• Precautionary Hoarding
• During Crisis a 1 percent rise in value of
  payment activity is associated with a 0.26 per
  cent rise in settlement banks overnight
  liquidity buffer
• Before Crisis no reaction
• Banks that disclosed a loss ratio of one standard
  deviation above the mean increased their
  overnight liquidity by an additional 25 per cent
  of a standard deviation

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Data on real-sector lending

• Fixed and Floating Rate
• New loans to Households and PNFC
• Spread to policy rate
• Growth rate of lending volume to Households and
  PNFC
• Source Bank of England Statistics Department
  MFSD data

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Transmission - I
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Transmission - II
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Economic significance

• Transmission
• Rates
• During Crisis A 1 basis point increase in
  secured spread causes a 1.3 basis points increase
  in the retail floating rate
• Before Crisis no effect
• All times A 1 basis point increase in secured
  spread causes a 1.4 basis points increase in
  corporate loans fixed rate
• Volumes
• During Crisis a 1 basis point rise in secured
  spread causes a 0.146 decline in growth rate
  corporate lending
• Before Crisis no effect

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Conclusion

• Evidence of precautionary liquidity hoardings
  during the crisis, with effect on inter-bank
  rates (secured, unsecured)
• The standard money-market arbitrage requires
  adjustment
• Why does the effect matter?
• Contagion from liquidity-strapped banks to others
  
• Transmission through rates to households,
  corporations
• Policy implications
• There seems at least an ex-post rationale for
  liquidity injections
• Can serve to eliminate liquidity-induced
  volatility and contagion
• Future work
• Examine money-markets bilaterally (market power,
  cornering)
• Study term-structure effects (substitution), if
  any