Working Paper: NBER ID: w13943
Authors: John B. Taylor; John C. Williams
Abstract: At the center of the financial market crisis of 2007-2008 was a highly unusual jump in spreads between the overnight inter-bank lending rate and term London inter-bank offer rates (Libor). Because many private loans are linked to Libor rates, the sharp increase in these spreads raised the cost of borrowing and interfered with monetary policy. The widening spreads became a major focus of the Federal Reserve, which took several actions -- including the introduction of a new term auction facility (TAF) --- to reduce them. This paper documents these developments and, using a no-arbitrage model of the term structure, tests various explanations, including increased risk and greater liquidity demands, while controlling for expectations of future interest rates. We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads. The results have implications for monetary policy and financial economics.
Keywords: financial crisis; money market; interbank lending; counterparty risk; monetary policy
JEL Codes: E43; E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased counterparty risk between banks (F65) | rise in spreads between the overnight interbank lending rate and the term LIBOR rates (E43) |
| TAF did not effectively reduce spreads (F38) | persistence of high spreads (F31) |
| introduction of TAF (Y20) | initial narrowing of spreads (G19) |
| initial narrowing of spreads (G19) | subsequent widening of spreads (G19) |