SYSTEMIC PERSPECTIVE OF TERM RISK IN BANK FUNDING MARKETS

Andrea Macrina and Obeid Mahomed
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Andrea Macrina: Department of Mathematics, University College London (UCL), Gower Street, London WC1E 6BT, UK2African Institute for Financial Markets and Risk Management (AIFMRM), University of Cape Town (UCT), Private Bag X3, Rondebosch 7701, South Africa
Obeid Mahomed: African Institute for Financial Markets and Risk Management (AIFMRM), University of Cape Town (UCT), Private Bag X3, Rondebosch 7701, South Africa

International Journal of Theoretical and Applied Finance (IJTAF), 2024, vol. 27, issue 03n04, 1-55

Abstract: The transition from term-based reference rates to overnight reference rates has created a dislocation in the market-making processes between the interbank and non-interbank funding, and their respective derivatives markets. This dislocation can be attributed to differences in funding and corresponding interest rate swap transactions, a thesis we explain and characterize in detail. It is then shown how this dislocation may be resolved. Based on a systemic perspective of a stylized financial system, an aggregated banking system is constructed that is void of idiosyncratic credit risks but still vulnerable to liquidity risks. Within this setup, a mathematical modeling framework for term-cognizant interest rate systems is derived that enables the pricing and valuation of bank term funding and associated derivatives transactions with varying liquidity characteristics. Other outcomes include: (i) a detailed analysis of the incomplete market paradigm that encapsulates bank term funding rates and the risk management processes involved therein; and (ii) a recovery of consistency in the pricing and valuation between funding and related interest rate swap transactions, along with a mechanism to exchange term risk.

Keywords: Term rates; interbank market; money market; interest rate derivatives; pricing kernels; liquidity risk; SONIA and SOFR; LIBOR transition; benchmark reform (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1142/S0219024924500018

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