Bank Liquidity and the Global Financial Crisis by Laura Chiaramonte

Author:Laura Chiaramonte
Language: eng
Format: epub, pdf
Publisher: Springer International Publishing, Cham

4.5 The Functioning of the Interbank Market During the Financial Crisis

For almost half a century, interbank markets were considered an example of efficiency and self-regulation. Liquidity was abundant, counterparty risks were deemed irrelevant: monetary authorities were able to govern the level of interest rates along nearly the entire maturity curve. 28 A strong contribution to the deposit supply and demand mechanism was given by the implicit guarantees offered by central banks and by the related market perception that no institution in major systemic countries would be allowed to fail due to international cooperation between the different monetary authorities.

The subprime mortgage crisis abruptly ended the favourable phase of limited variability and low-risk premiums, triggering the reorganization of monetary and financial markets. In the new configuration, tensions were rife in the interbank deposit market with an increase in spreads for bank bonds, indicating a higher funding cost for banks. Since August 2007, an unexpected increase in liquidity demand by banks, to meet their commitments to SIVs and for precautionary purposes, added to the perception of growing counterparty risk, caused tension on interbank markets. Uncertainty regarding the creditworthiness of each interbank counterparty is associated with both the opacity of some markets, particularly where credit derivatives (such as CDSs) shown in the Financial Statements of some banks are traded, and the consequently difficult evaluation of toxic securities (ABSs and CDOs) and the potential losses linked to these bonds.

The low liquidity of structured credit instruments and the issue of credit risk identification and measurement increased the difficulties of assessing counterparty risk and created initial tensions on the interbank market, immediately manifested in the form of a drop in the volumes traded, the increase in interest rates beyond short maturities, and flight to overnight, i.e. the concentration of volumes on overnight maturities. In the initial phase of the crisis, monetary policy rates and interbank market began to significantly diverge, irrespective of the will of the central banks.

Therefore, the gradual paralysis of interbank exchanges was not due to specific technical shortcomings in the trading markets but to a sharp drop in confidence among banks themselves, unwilling to lend each other funds for other than short periods due to the fear of becoming involved in the crisis of the debtor bank and/or to disclose to the market, or simply raise the suspicion of weakness in their liquidity position, via the trades they put on the table.

During the crisis, at least as far as the Italian market is concerned, episodes of distrust did not concern depositors, but the banks themselves. The diminished confidence in interbank market operators was not reflected solely in the reduced duration and volume of deposits and the greater selectivity of counterparties (as shown by the fall in exchanges between national and foreign intermediaries on an unsured basis), but led to a revision of the operation, which now involves both a greater use of collateralized loans and forms of bargaining through bilateral auction mechanisms or between a limited number of counterparts (request for quote, RFQ), as introduced by some electronic trading platforms.

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