The short-term segment of the yield curve could be estimated using various types of data extracted from shot-term instruments traded on the London money market such as general collateral (GC) repo agreements, conventional gilt yields, interbank loans, short futures contracts, forward-rate agreements and swap contracts settled on the sterling overnight interest rate average (SONIA). While the GC repo rates and treasury bills (T-bills) could provide virtual risk-free short-term interest rates, both types of instruments are likely to be affected by factors like small outstanding stock and gilt collateral unavailability (Anderson and Sleath, 1999).
For this study, the interbank segment of the money market will be considered. The interbank market facilitates the transfer of created funds from one bank to another, in order to meet liquidity and reserve requirements. Banks with excess liquidity will offer unsecured short-term loans to banks in need of funds, charging for this service a certain interest rate. Numerous interbank rates are published daily; the most renowned ones include the LIBOR- London Inter Bank Offer Rates (UK), EURIBOR (Eurozone) and FIBOR (Germany).
LIBOR rates are employed in the current empirical analysis. During the sampling period the LIBOR rates were still under the supervision of the British Bankers’
Association (BBA) with assistance from the Foreign Exchange and Money Markets Committee (FX & MMC). LIBOR rates were determined using a robust methodology:
BBA would select and pool together the panel banks - the most representative financial institutions that actively trade in each currency interbank markets. The offer/lending rates submitted by these banks were used to produce the official LIBOR rates, also called BBA interest settlement rates. LIBOR rates were calculated as an average after the first and last quartiles have been eliminated. Starting with only three currencies (USD, GBP and JPY), the number of LIBOR currencies grew to sixteen prior to 2000, and then dropped to ten, following the creation of the Euro currency. For nearly three decades11 the BBA was responsible for the complex process of daily calculation of 150 LIBOR rates published by Thomson Reuters on behalf of the BBA. However, after the 2012 LIBOR fixing scandal,
11 The first LIBOR interest rates were published in 1986.
86 the BBA was suspended from its governing role over LIBOR. Starting from June 2013 the collection, the calculation and the distribution of the LIBOR rates have been subject to major regulatory reforms. While LIBOR data distribution was unaffected by these statutory amendments, significant changes had to be implemented, including the ceasing of the publication of certain LIBOR currencies and maturities. The Australian and Canadian dollar were the last currencies to be removed from the LIBOR framework with effect from June 2013, with only five currencies being retained: GBP, USD, EUR, JPY and CHF. Also, the nine-month tenor has been excluded from all remaining currencies due to reduced volume of regular transactions. This implementation has considerably affected the market participants12 whose operations made use of this maturity LIBOR rate, and who have to find different appropriate alternatives such as various interpolation methods or other industry benchmark rates.
Despite these events, LIBOR interest rates are still generally accepted as the lowest interbank lending rates on the London money market. Moreover, they are considered the most important benchmark in the global financial markets for short-term interest rates.
Banks use LIBOR as a base rate in calculating their interest rates for loans, mortgages and deposits, whereas financial markets use LIBOR as a base rate in pricing derivatives such as futures, swaps and options.
Given the importance of LIBOR as a benchmark for pricing many financial products, any dysfunctionality in the unsecured interbank lending market will have wide-reaching repercussions on the financial system and on the real economy. During the global financial turmoil of 2007-2009 this aspect was highly relevant, with a starting point in August 2007 when the interbank lending market had to be saved by liquidity injections from both the European Central Bank and the Federal Reserve (see Brunnermeier, 2009).
While the crisis has been driven by the problems in the asset-backed securities market in the U.S., other markets such as the Repo and LIBOR markets became also unstable. The interbank market became impaired as banks were reluctant to lend to each other as a cautious measure and as a result of unknown counterparty exposure to asset-backed securities. Consequently, this created a complicated liquidity deadlock, in the sense that the availability of short-term funding was substantially reduced with an immediate decreasing effect on the level of interbank interest rates. This culminated with a credit crunch and a frozen liquidity flow in the interbank markets in the autumn of 2008 when
12 The nine-month tenor LIBOR rates were initially included in the data for this study; however, because it has been discontinued, the two-month maturity rates have been considered instead.
87 unsecured interbank lending at 3-month was almost replaced by secured overnight borrowing (Acharya et al. 2009).
Since trading international currencies has become a standard activity in the banking industry, extensive comparative empirical studies for different markets13 have always provided researchers in the field with valuable insightful information. For this study, the five currencies were carefully chosen based on the importance of the economies worldwide and on the particularities of their financial systems and financial regulatory bodies. In this respect, Japan, as the third power in the global economy, has known considerable uncertainty despite artificial maintenance of extremely low interest rates, while Canada, with very close economic connections to the U.S., but with a conservative banking system closer to the U.K. system, seems to have been least affected by the last global financial crisis. The other three markets the U.K., the US and the Eurozone are the major players in ensuring worldwide financial stability, hence developing interest rate models with improved forecasting power for these markets is of great importance.
The maturity spectrum of the LIBOR rates has been reduced to only seven maturities in the aftermath of the LIBOR scandal in 2012. For estimating the LIBOR curves for the above markets five maturities are utilised, namely one-week, one-, three-, six- and twelve-months. The one, three and six-month LIBOR rates are the most used LIBOR rates, being used to index over $360 trillion of notional financial contracts, from interest rate swaps and other derivatives to floating-rate residential and commercial mortgages. One may argue that the 6-month LIBOR is the most important of the LIBOR rates, being the choice by default reference index rate in most interest rate swap contracts that operate with six-month tenors. Hence, this rate has a direct connection with the swap markets and payments linked to this rate are mainly driven by investors in longer term swap markets. The other important determinant of LIBOR rates is the mortgage and securitization markets. The investors in these latter markets require a quarterly payment structure and in order to avoid interest rate risk exposure, naturally they would like to receive their coupons linked to 3-month LIBOR. Furthermore, the mortgage markets are organised around monthly payments by mortgage borrowers. Hence, mortgage provides are interested in 1-month LIBOR in order to hedge their interest rate risk exposure.
At the very end of the money market rate spectrum, the 12-month LIBOR is a deposit rate but it is also a rate that can be recovered from FRA/futures contracts and it may even be a
13 Previous extensive empirical studies include: Tse (1995) who considered money market rates for eleven countries; Dahlquist (1996) who analysed rates for the UK, Germany, Denmark and Sweden; Episcopos (2000) who investigated the dynamics of interbank rates for ten countries.
88 reference rate in occasional short-term swaps. Last but not least, the one-week LIBOR has more features associated with repo and overnight swap rates.
The LIBOR rates mentioned above correspond to different types of derivatives markets and will respond differently to a specific type of information/shock in the financial markets, albeit there is an obvious common ground. Acharya and Skeie (2011) emphasized that stress and freezes in term inter-bank lending markets may be the result of rollover risk of highly leveraged lenders and illiquidity of assets underlying term loans.
They showed that the term inter-bank lending rates and volumes are jointly determined, lenders and aversion of borrowers to trade at high rates of interest playing a very important role. While the levels of the interest rates are highly correlated, the stationarity analysis shows that it is the first difference series that is stationary. Therefore, the relevant correlations are those of first differences. The sample correlations for the first difference series revealed in Table 3.13, that adjacent LIBORs are more correlated but correlations for more distant LIBORs are weaker, therefore it is the changes in the LIBOR rates of different maturities that bring new information into the dynamic continuous interest models.
The consequences of LIBOR manipulation could be very serious, as the LIBOR rates submissions don’t portray the true market forces and therefore may result in misallocation of resources and price distortions in the economy (see Abrantes-Metz et al. (2012).
Lower LIBOR rates imply lower mortgage and hence the 1-month LIBOR rates could have been most affected in comparison with other maturity LIBOR rates. While there are no comparative studies to assess which of the seven maturity LIBOR rates have been mostly affected, Monticini and Thornton (2013) found that the average of one- and three-month LIBOR – CD spreads declined by nearly 5.5 basis points by mid-2007. In addition, McConnell (2013) provides evidence from the regulators’ investigations that followed the LIBOR scandal in 2012, that the one- and three-month LIBOR have been subject to systematic manipulation within and across participating banks. Further, he describes the LIBOR fixing as an example of systemic operational risk, more specifically - people risk, and suggests to banks and regulators some recommendations about how to address the management of systemic people risk.