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Understanding liquidity and credit risks in the financial crisis.

Research output: Contribution to journalJournal article

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<mark>Journal publication date</mark>12/2011
<mark>Journal</mark>Journal of Empirical Finance
Issue number5
Volume18
Number of pages12
Pages (from-to)903-914
Publication statusPublished
Original languageEnglish

Abstract

This paper develops a structured dynamic factor model for the spreads between London Interbank Offered Rate (LIBOR) and overnight index swap (OIS) rates for a panel of banks. Our model involves latent factors which reflect liquidity and credit risk. Our empirical results show that surges in the short term LIBOR-OIS spreads during the 2007–2009 financial crisis were largely driven by liquidity risk. However, credit risk played a more significant role in the longer term (twelve-month) LIBOR-OIS spread. The liquidity risk factors are more volatile than the credit risk factor. Most of the familiar events in the financial crisis are linked more to movements in liquidity risk than credit risk.