Implicit intraday interest rate in the UK unsecured overnight money market by Marius Jurgilas and Filip Žikeš
Almost all central banks differentiate between overnight and intraday liquidity in their monetary frameworks either explicitly, in terms of the interest rates charged, or implicitly, via different eligibility criteria for acceptable collateral. While the overnight market is the most liquid interbank market, there is no explicit private intraday money market in which counterparties contract to deliver funds at a specific time of the day. This is puzzling since various empirical and theoretical studies show that the participants of the payment systems have incentives to delay the settlement of non-contractual payment obligations.
We test the hypothesis of a positive intraday interest rate implicit in the UK overnight money market. Our hypothesis is that although there is no explicit intraday money market, the pricing of overnight loans of different lengths is consistent with the existence of an implicit intraday money market. We believe that overnight loans provide dual service to the participants of the money market. First, overnight loans allow banks to smooth day-to-day imbalances and achieve targeted end of the day reserve balance positions. Second, managing the timing of overnight loan advances and repayments allows banks to smooth intraday imbalances of payment flows. We show that these two components have different effects on the pricing of the overnight loans.
Our empirical results lead us to conclude that the pricing of overnight loans in the UK money market is consistent with the existence of an implicit intraday money market. While the average implicit hourly intraday interest rate is quite small in the pre-crisis period (0.1 basis points), it increases more than tenfold during the financial crisis (1.56 basis points). For an average loan of £65 million, advancing the loan one hour earlier in the day increases the interest payment by an estimated £2,778 in the crisis period. We also observe an increase in the implied loan rate during the last hour of trading. As expected, the end of the day effect is most pronounced during the period without reserves averaging as the settlement banks had to meet the ‘target’ of a non-negative overnight reserve balance each day.
The main policy implication of our work is that the opportunity cost of collateral pledged to obtain intraday liquidity from the Bank of England can become significant during market distress. This can create an incentive for banks to delay payments, as the intraday value of liquidity rises substantially. Through this channel the financial system under stress can become subject to further market pressure. To avoid possible payment delays, CHAPS participants are subject to throughput guidelines that prescribe a percentage of payments that need to be processed before certain thresholds during the day. But the Bank of England’s Payment Systems Oversight Report 2008 shows that even with throughput guidelines, CHAPS banks started delaying payments after the collapse of Lehman Brothers. In light of our results, we suggest that the implicit intraday interest rate can be used as an indicator of emerging intraday liquidity concerns in payment systems.
©2012 ALL RIGHTS RESERVED THE AUTHOR(S) AND THE PUBLISHER