We are very grateful to two anonymous referees and participants at the Freiburg Institute of Advanced Studies Workshop and Conference on ‘Information, Liquidity and Trust in Incomplete Financial Markets’, held respectively in Eltville am Rhein, Frankfurt, Germany, 15–17 March 2010, and Freiburg, Germany, 11–13 October 2010, for useful comments on an earlier version of this paper. The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank.
LIQUIDITY RISK, CREDIT RISK AND THE OVERNIGHT INTEREST RATE SPREAD: A STOCHASTIC VOLATILITY MODELLING APPROACH*
Version of Record online: 27 SEP 2012
© 2012 The Authors. The Manchester School © 2012 John Wiley & Sons Ltd and The University of Manchester
The Manchester School
Volume 81, Issue 6, pages 925–940, December 2013
How to Cite
BEIRNE, J., CAPORALE, G. M. and SPAGNOLO, N. (2013), LIQUIDITY RISK, CREDIT RISK AND THE OVERNIGHT INTEREST RATE SPREAD: A STOCHASTIC VOLATILITY MODELLING APPROACH. The Manchester School, 81: 925–940. doi: 10.1111/j.1467-9957.2012.02330.x
Manuscript received 17.11.10; final version received 3.7.12.
- Issue online: 8 OCT 2013
- Version of Record online: 27 SEP 2012
In this paper we model the volatility of the spread between the overnight interest rate and the central bank policy rate (the policy spread) for the euro area and the UK during the two main phases of the financial crisis that began in late 2007. We find a strong role played by liquidity risk volatility, but also private bank credit risk volatility after the collapse of Lehman Brothers. The main implication is that, in crisis times, a sufficiently flexible operational framework for monetary policy implementation produces the most timely response to market tensions.