An early warning indicator for liquidity shortages in the interbank market

• Author: Andrew Urquhart,Simon Wolfe,Andrea Eross
• DOI: http://doi.org/10.1002/ijfe.1719
• Date: 01 July 2019
• Published date: 01 July 2019

Received: 27 October 2016 Accepted: 30 December 2018

DOI: 10.1002/ijfe.1719

RESEARCH ARTICLE

An early warning indicator for liquidity shortages in the

interbank market

Andrea Eross1Andrew Urquhart2Simon Wolfe3

1School of Social Sciences, Heriot-Watt

University, Edinburgh, UK

2ICMA Centre, Henley Business School,

University of Reading, Reading, UK

3Southampton Business School, University

of Southampton, Southampton, UK

Correspondence

Andrea Eross, School of Social Sciences,

Heriot-WattUniversity, Edinburgh, UK.

Email: a.eross@hw.ac.uk

JEL Classification: C11; F37; G01

Abstract

This study investigates an early warning indicator for liquidity shortages in

the short-term interbank market. To identify structural breaks and their per-

sistence, an autoregressive two-state regime switching model is presented. The

variability in the LIBOR–OIS spread along with thresholds, which delimit four

intensities, reveals regime changes consistent with liquidity crashes. The tran-

sition between the states is state dependent, and the posterior estimates for the

crisis and noncrisis states are estimated using the Gibbs sampler. We forecast

our early warning indicator up to December 2011 and show that the estimates

are superior to a random walk with drift. Therefore, the model is an effec-

tive early warning indicator of an imminent liquidity shortage impacting the

interbank market.

KEYWORDS

Bayesian inference, early warning indicator, interbank market, liquidity crises, regime switching

1INTRODUCTION

The financial crisis of 2007–2008 is recognized to be the

worst crisis since the Great Depression of the 1930s, and as

a result, liquidity risk in the interbank market has gained

increased attention. There is widespread agreement that

the two main causes of the 2007–2008 credit crisis were

inadequate liquidity buffers held by banks and lax regula-

tionin thefinancial system.However, thereisa viewthat the

trigger point was a decade earlier, when the U.S. Treasury

lowered interest rates to a previously unseen level and kept

them there for a prolonged period of time (Economist,

2013). From a monetary policy perspective, the focus was

on maintaining low consumer price inflation while ignor-

ing the widespread development of asset price inflation.

Consequently,excess liquidity built up in the financial sys-

tem. This coupled with lack of prudent liquidity measures

and prompt reactions led to financial instability.

The global financial crisis was a black swan event,

as neither the academic finance community nor finance

industry anticipated it. In light of the 2007–2008 liquid-

ity crisis, our study investigates whether there was an

early warning signal before the crisis erupted. More pre-

cisely,the analysis is concerned with revealing whether the

short-term interbank spread (U.S.London Interbank Offer

Rate–Overnight Interest Swap [LIBOR–OIS]) can predict

crises, and consequently, what are the implications for

liquidity risk management. Financial crises are character-

ized by depth and have their own accelerating moments.

To avoid contraction of market activity, sound liquidity

management should be in place, and thus, in times of

financial distress, pivotal actions can be taken. Measuring

liquidity risk is a prerequisite, and consequently, early

warning indicators should be part of sound liquidity man-

agement strategies. Triggers, perceived as risk indicators,

are explicit early warning signs for each phase (determined

by an arbitrary threshold) in a liquidity crisis.

To addressthe above issues, a regime switching model is

proposed that provides the probability of being in a liquid-

ity crisis state at any given instance.1The model is assessed

1300 © 2019 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/ijfe IntJ Fin Econ. 2019;24:1300–1312.