Final Report Summary - OVERNIGHT VOLATILITY (Overnight Volatility in Financial Markets: Causes and Consequences)
This project consisted of two stages. In the outgoing phase of the project, Dr. Demiralp visited the Board of Governors of the Federal Reserve System in Washington, DC for one year. In the returning phase, she resumed her position as an Associate Professor of Economics at Koc University. Multiple work packages of the project evolved around the general theme of overnight volatility (OV). These work packages investigated and established the role of overnight volatility in the monetary transmission mechanism. The conclusions of the project shed light onto different aspects of volatility and the effectiveness of policies developed by central banks during the financial crisis.
Dr. Demiralp’s main results reflect that overnight volatility plays an essential role in the monetary transmission mechanism particularly during times of financial crisis. An increase in overnight volatility generates more uncertainty and inhibits lending behavior. Hence, central banks should aim to develop policies that stabilize overnight volatility in money markets. Dr. Demiralp’s findings suggest that the policies developed by the Federal Reserve and the ECB were effective in containing the crisis.
Work Package 1 (WP1):
The main finding in this WP is that federal funds rate volatility is associated with higher risk premium and hence contributed to elevated Libor-OIS spread during the financial crisis of 2007-2009. These results have implications of different operating environments for the implementation of monetary policy. For example, if overnight rates are volatile because of the operating framework, longer-term rates will be higher than otherwise, suggesting that the overall stance of policy is tighter for a given average level of the federal funds rate. These results from the WP1 can be utilized by the central banks in designing the stance of monetary policy.
Work Package 2 (WP2):
WP2 conducted a comparative analysis between the effects of non-standard policies adopted by the Federal Reserve and the ECB during the financial crisis. By estimating the impact of central bank policies on OV, WP2 quantified the impact of these policies on bank loans in the two regions. The results suggest that non-standard policy measures lowered bank funding volatility. Lower bank funding volatility in turn increased loan supply in both regions, contributing to sustained lending activity. This is considered as strong evidence for a “bank liquidity risk channel”. This channel is operative in crisis environments, which complements the usual channels of transmission of monetary policy.
The estimated impact of non-standard measures on bank loans is larger in the US. The analysis suggests that in the absence of such measures, Commercial and Industrial loans would have been lower by at least 2 ½ percent in the US while loans to Non-financial corporations in the Euro Area would have been only 1 percent lower in the absence of non-standard measures.
Work package 3 (WP3):
WP3 developed a measure for money market stress for the US. WP3 showed that the crisis period has been characterized by three distinct phases—states of low, high, and extreme stress. The switches from high to low stress states generally coincide with various actions by the Federal Reserve that are intended to alleviate funding stress. In the aftermath of the crisis, it is found that the level of stress in money markets is generally low with the exception of a brief period in mid-2010 and late-2011.
Work package 4 (WP4):
WP4 utilized the cross sectional differences among financial institutions in the US by using bank-level data. It focused on the effects of TAF (Term Auction Facility) and TARP (Troubled Assets Relief Program) on loans extended by U.S. banks abstracting from the question of whether the programs independently affected bank failure rates. The results suggest that bank loans increased at institutions receiving TAF funds while TARP funding was not associated with subsequent loan growth.
Work package 5 (WP5):
Large scale asset purchases (LSAPs) have become an important tool of the Federal Reserve in recent years. WP5 exploited Flow of Funds data to assess the types of investors that are selling to the Federal Reserve and their portfolio adjustments after these sales, which could provide a view to the plausibility of preferred habitat models and the transmission of unconventional monetary policy across asset markets. WP5 found that the Federal Reserve is ultimately buying from only a handful of investor types, primarily households, with a different reaction to changes in Federal Reserve holdings of longer-term versus shorter-term assets. Although not evident for all investors, the key participants are shown to rebalance their portfolios toward more risky assets during this period. These results can be interpreted as supporting, at least in part, the preferred habit theory and the view that the monetary policy transmission is working across asset markets.
Work package 6 (WP6):
Using the Factiva archives to construct a database that tracks the days on which politicians comment about the monetary policy, WP6 analyzed the impact of political commentaries on financial market volatility for the US and the EA. The findings suggest that political commentaries do influence policy rate expectations in the Euro Area, even after controlling for macroeconomic releases and immediate interest rate expectations. For the United States, such evidence is rather limited. The findings regarding the policy reaction functions reveal that market expectations are mostly rational. There is no evidence that the Federal Reserve responds to political commentaries. Meanwhile the European Central Bank seems to have steered its policy in line with political commentaries that suggested further easings during the pre-crisis period consistent with market expectations.