Abstract - The term structure of interbank risk
Interbank risk has become a key issue since the start of the financial crisis. Most existing studies proxy interbank risk by the spread between a LIBOR rate and the rate on an overnight indexed swap (OIS) of identical maturity. In this paper, we use the term structure of spreads between rates on interest rate swaps indexed to LIBOR and OISs 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. The non-default component is relatively more important in the first half of the sample and is correlated with various measures of market-wide liquidity. 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 the pricing, hedging and risk-management in the interest rate swap market.
École polytechnique fédérale de Lausanne