Credit risk is defined as the, “Potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms”(Bank of International Settlement(BIS), 2000). Arguable, credit risk has become the “Greatest risk facing a bank…one for which the most regulatory capital is required”(Hull 2015 pg. 41). Indeed this holds true as within the Basel III framework “The total capital ratio must be no lower than 8%”(Bank of International Settlement) for banks. Furthermore, for credit risks in banks, capital is chosen so that, “The chance of unexpected losses exceeds the capital in a year”( Hull 2015, pg. 42). This is set to cushion the adverse effects these institutions may face, with once such event being Brexit.
Indeed, the management of credit risk can be viewed as the ‘Passport of Banks’ where essentially, effective management will secure a banks position and its operational health within the economy. This metaphorical analogy refers to the notion of such risk being a detrimental factor to the take off, duration and landing of any bank within an economy, that is, the banks reputation and survival to keep afloat within the economy amid any internal or external factors. After all, “A banks reputation is its most valuable asset”(Hull 2015, pg. 39). With such risk faced by banks globally, one particular measure used to capture the healthiness or creditworthiness of a baking system is the LIBOR-OIS spread. Separately, the British Bankers association states that Libor rate “Reflects the rate at which the panel banks can raise unsecured cash in the interbank lending markets…measures of a typical creditworthy bank’s marginal cost of unsecured term funding”(The British Bankers Association, 2008). Alternatively, the OIS rate is defined as the “Market’s expectation of the path of unsecured overnight rates and of policy rates in a specific currency”(Cui et al 2016, pg. 2). When both rates are combined and used within the interbank lending market, this forms the LIBOR-OIS Spread defined as the “Spread between three-month LIBOR and the three month OIS swap rate”(Hull and White 2013, pg. 8). Furthermore, Hull suggests that it “Reflects the difference between the credit risk in a three-month loan to a bank that is considered to be of acceptable credit quality and the credit risk in continually-refreshed one-day loans to banks that are considered to be of acceptable credit quality”(Hull and White 2013, pg. 8). From this, we can safely say that the LIBOR-spread reflects the creditworthiness of banks. Indeed, Cui et al states that the spread “Strips out the effects of policy rate expectations and leaves a measure of interbank rate stress and credit concerns,viewed as a banking system health indicator”(Cui 2016, pg. 2). Within the literature, there are varying views as to what the spread represents. Giavazzi states that the European view of the spread “Reflects credit risk…as LIBOR loans are not collateralised…LIBOR loans are risky and the spread simply reflects the market assessment of such risk”(Giavazzi 2008). Alternatively, he states that the American view of the spread “Underlies the shortage of bank capital”(Giavazzi 2008). With this, this paper in particular will focuses on the former view.
The key question which frames this paper is ‘What determines the level of the spread?’. In particular, I ask; ‘Does the uncertainty of the referendum characterised by credit risk components, effectively determines the level of the spread?’. Before making an assessment on this, it is important to consider the literature surrounding the determinants of the spread. The Bank of England attributed that “Liquidity risk is the main driver of the spread in early crisis periods while credit risk premium accounts for movements months after the initial crisis in 2007″(Bank of England 2007). Furthermore, the European Central Bank(ECB) suggest that both, “Credit and liquidity risk account equally for increases in the Libor-OIS spread”(ECB, 2008). Taylor and William 2009 OLS regression model study show that, increased counterparts risk between banks is the main driver of the widening Libor-OIS spreads”(Taylor and William 2009 pg. 57), Furthermore, they concluded that “The estimates of the credit risk proxies are found to have the expected sign and are usually significantly different from zero”(Taylor and William 2009 pg.72). In addition, a study by Gonzales-Hermosillo and Stone 2008 examines 6 potential risk measures of the spread to find that “Systematic distress risk is the dominant driver of the spread”(Gonzales-Hermosillo and Stone 2008). On the contrary, Michaud and Upper (2008) examined the LIBOR-OIS spread in a number of currencies where they find that the LIBOR-OIS spreads tracked measures of credit risk and acknowledge that the “Looseness in this relationship reflects the impact of liquidity factors”(Michaud and Upper, 2008). The extent of liquidity risk being more of a driver is also confirmed by Poskitt’s 2011 study where his decomposition analysis shows that “Liquidity components invariably exceeded the credit risk component…variations in the liquidity component were largely responsible for the dramatic swings in the LIBOR-OIS spread”(Poskitt’s 2011, pg.9). Frank and Hesse (2009) also decompose the US dollar LIBOR-OIS spread into credit risk and non-credit risk components using CDS premia on LIBOR panel banks. Their results suggest that “Daily changes in the non-credit risk component were overwhelmingly positive prior to the December 2007 monetary policy initiatives and overwhelmingly negative in the days that followed these initiatives”(Frank and Hesse 2009). From the above literature, this paper stands aside from the rest as it explores a more recent phenomenon, Brexit, and will extend pervious literature on credit risk components being the main driver of changes in the spread.