The following post is based on the research paper tilted “Asymmetric Convergence and Risk Shift in the LIBOR-T Bill Spreads” co-authored by Shawkat Hammoudeh and Yuan Yuan, both at Drexel University, and Li-Hsueh Chen at California State University-Los Angeles.

The 2007-2008 US credit crisis brought up London Interbank Offered Rate (LIBOR) into the financial spot light after it was a forgotten part of the financial landscape.[1]  LIBOR rates are widely used as a reference rate for many financial instruments, and they provide the basis for some of the world's most liquid and active interest rate markets. The rates on borrowed funds (adjustable-rate mortgages, corporate loans, private student loans …etc), amounting to about $10 trillion, are tied to LIBOR. For example, the LIBOR rate determines the monthly payments on about half of the adjustable-rate mortgages in the United States since the mortgage rate is set as LIBOR plus a fixed margin. LIBOR is also an even more important financial instrument in the enormous market for interest-rate swaps. The total amounts involved in this market, when added up across the world, exceed $300 trillion (Mackenzie, 2008).[2] LIBOR is an interest rate measure that is unambiguous and credible enough to shape the basis for swaps contracts denominated in billions of dollars. Therefore, combining them with the risk-free Treasury bill rates provides a reliable measure of credit risk in the interest rate markets. With banks unwilling to lend to businesses, individuals and to each other, and monetary policy highly ineffective, the relationship between LIBOR and comparable risk-free US Treasury bill rates is currently looked at as a gauge of financial health. It should not be a surprise that LIBOR rates are used in connection with Treasury bill rates to form credit spreads as a measure of systemic credit risk.

A hike or widening in the spread between those rates is considered a sign of increasing risk in the financial system. In this case, banks opt to invest their funds in buying the safe haven Treasury bills, instead of lending at the prevailing LIBOR rate to other banks that may have questionable balance sheets. This is the case that has plagued the banks since the capital meltdown in summer 2007. The three-month spread, for example, widened from less than 50 basis points during most of the first half of 2007 to 281 basis points on September 1, 2008 as a result of the repeated negative shocks that have hit the credit markets since summer 2007. The 12-month spread reached 320 basis points on the latter date. On the other hand, a narrowing in the credit spread to its historic average can be viewed as a signal of returning to normality and a precursor for stimulation of aggregate demand to generate economic activity. This is the case the Fed hopes to achieve out of using the TARP money.

Our research shows that the spreads comprise LIBOR and Treasury bill rates in each of the three-month, six-month and 12-month maturity markets have asymmetrical adjustments to their historical averages as stability comes back to the system. They behave differently after a positive shock (such as news of new capital injected in the banks) strikes the credit markets than after a negative shock (such as news of a collapse of a large investment bank hits). That is, stability does not come back evenly or uniformly after different shocks hit. Therefore, the spreads’ widenings and narrowings have different speeds of adjustment, reflecting asymmetric information between lending and borrowing banks, different treatments of risk and/or different asymmetric effectiveness on part of monetary policy. Specifically, the three- and six-month spreads have much faster speeds of adjustment under widenings after a negative shock takes place during troubled times as such as the period 2007-2009, that is when the credit markets shift into a higher risk level, compared to widenings during normal risk times. This is because more risk is moved to the front months of the maturity spectrum by safe haven seekers operating in the high risk environment during the current period. LIBOR rate are not responsive in such an environment. This is an adjustment in the presence of a double-whammy for those shorter maturities, similar to the events of 2008 and 2009. The case is different for the 12-month maturity where the spread is much fatter and much slower in moving to historical averages during widening after negative shocks strike under higher risk times than during normal times such as the period before summer 2007.  This case reflects aversion of risk, fewer profitable opportunities and/or less effective role for monetary policy in high risk environment. On the other hand, the 12-month spread moves faster than the shorter maturities in the normal risk environment such as the period before summer 2007 after positive shocks take place leading to narrowings.

The findings imply that traders and policy makers are more efficient or successful in the longer-term maturities after positive shocks occur, in normal times. On the other hand, they are more efficient in the shorter-term maturities after negative stocks hit their market, particularly when the level of risk is high. They also imply that conventional monetary policy is not effective in the longer maturity (12 months) under spread widenings in both risk environments because the coefficient for the Treasury bill rate is not significant. This implies that in both normal and high risk environments, conventional expansionary monetary policy works through shorter and not through longer maturity Treasury bill rates, regardless of the risk level. Thus, the monetary authority should focus on buying shorter-term government securities to nudge the spread closer to the historical averages to restore stability to the financial system in the short run.. In the longer term maturity, Treasury bill rates are not responsive to monetary policy and unconventional monetary policy should be followed to move the LIBOR rates.

Under spread narrowings, monetary policy is more effective in the longer (12 month) than the short term maturities before summer of 2007 because the risk level is normal. This implies that monetary tightening in normal risk environments works through selling both shorter and longer term government securities but it may achieve better results in the longer maturity. In the high risk period that followed summer 2007, contractionary monetary policy is not effective in the six- and 12- month maturities in this high risk environment. Therefore, the goals of monetary tightening can be achieved through selling conventional three month government securities. This is the toughest scenario for the monetary authority.

In such situations, policy makers should understand the causes behind a tardy adjustment in the longer-term maturity and the fast adjustment in the shorter-term maturity after negative shocks take place in these markets. Is this because of lack of liquidity, less profitable opportunity or higher risk? If the reasons have to do with higher risk, then financial authorities should find ways to reduce risk (such as requiring better disclosures and transparency, and offering more adequate regulations and guarantees such as higher capital and collatural requirements). If the reasons have to do with lack of liquidity, then financial authorities should find ways to increase liquidity by, for example, making the discount windows more accessible and creating new lending facilities to commercial and noncommercial banks etc.

Any misdiagnosis of the reasons will lead to the prescription of the wrong policies as John Taylor wrote recently.[3] The fast convergence of the shorter-term than the longer term maturities during negative shocks and under higher risk levels indicates that the reason for the crisis in 2007-2009 has more to do with risk than liquidity. Capital moves to the shorter maturity after negative shocks occur in a high risk environment seeking a safe haven.

[1] 150 LIBOR rates are published daily, for 10 currencies for durations that range from one over night to 12 months. Here we examine the US dollar LIBOR.

[2] Mackenzie, D. 2008.What’s in a number? http://www.lrb.co.uk/v30/n18/mack01.html

[3] John B. Taylor “How Government Created the Financial Crisis,” Wall Street Journal (P. A 19), February 9, 2009