The Term Structure of Interbank Risk

We use the term structure of spreads between rates on interest rate swaps indexed to LIBOR and overnight indexed swaps to infer a term structure of interbank risk. We develop a dynamic term structure model with default risk in the interbank market that, in conjunction with information from the credit default swap market, allows us to decompose the term structure of interbank risk into default and non-default components. On average, from August 2007 to January 2011, the fraction of total interbank risk due to default risk increases with maturity. At the short end of the term structure, the non-default component is important in the first half of the sample and is correlated with various measures of market-wide liquidity. Further out the term structure, the default component is the dominant driver of interbank risk throughout the sample period. These results hold true in both the USD and EUR markets and are robust to different model parameterizations and measures of interbank default risk. The analysis has implications for monetary and regulatory policy as well as for pricing, hedging, and risk-management in the interest rate swap market. JEL Classification: E43, G12 CONTAINS ONLINE APPENDIX This version: September 2011 ——————————— We thank Joao Cocco, Rudiger Fahlenbrach, Peter Feldhutter, Michael Fleming, Mikael Jensen, Holger Kraft, David Lando, Jesper Lund, Claus Munk, Alberto Plazzi, Olivier Scalliet, and seminar participants at the Conference on Mathematical Modeling of Systemic Risk, the 2011 FINRISK research day, the Goethe University in Frankfurt, the University of Southern Denmark, the University of St. Gallen, and the EPFL-UNIL brownbag for comments. Shadi Akiki provided excellent research assistance. E-mails: [email protected] and [email protected]. Both authors gratefully acknowledge research support from NCCR FINRISK of the Swiss National Science Foundation. “The age of innocence – when banks lent to each other unsecured for three months or longer at only a small premium to expected policy rates – will not quickly, if ever, return”. Mervin King, Bank of England Governor, 21 October 2008