An International Examination of the Role of Default and Liquidity Risks in the Interbank Market

We estimate a no-arbitrage model of the term structure of international interbank spreads, and attempt to disentangle credit and liquidity risk premium in the interbank market. We study the consistency of the spreads' movements across major currencies and assess the effectiveness of monetary policy actions on the deterioration of credit and liquidity risks. We find that at the core of the financial crisis, the interbank spread is clearly driven by liquidity risk. The effect is stronger in the US market, where liquidity pressures were severe. Our analysis suggests that the establishment of the unconventional policy programs, led to the deterioration of liquidity risk in the interbank market. Furthermore, the policy of major Central banks to substantially cut interest rates, kept credit pressures at low levels. By early 2009, the dominant driver of the spread is credit risk. This effect is stronger in the Euro and UK markets, due to the escalation of the European sovereign debt crisis. This is not the case for the Japanese market, which experienced remarkably low credit pressures during the core of the crisis. Moreover, we decompose the spread into an expectation hypothesis component and a time-varying risk premia component and find that the hypothesis of constant risk premia is rejected