In The Financial Crisis and the Policy Responses- An Empirical Analysis of What Went Wrong John Taylor concludes that the primary driver was not liquidity, but counterparty risk:
2.1 Diagnosing the Problem: Liquidity or Counterparty Risk?
Diagnosing the reason for the increased spreads was essential, of course, for determining what type of policy response was necessary. If it was a liquidity problem then providing more liquidity by making discount window borrowing easier or opening new windows or facilities would be appropriate. But if the issue was counterparty risk then a direct focus on the quality and transparency of the bank’s balance sheets would be appropriate, either by requiring more transparency, dealing directly with the increasing number of mortgage defaults as housing prices fell, or looking for ways to bring more capital into the banks and other financial institutions.
In the fall of 2007 John Williams and I embarked on what we thought would be an interesting and possibly policy relevant research project [3] to examine the issue. We interviewed traders who deal in the interbank market and we looked for measures of counterparty risk. The idea that counterparty risk was the reason for the increased spreads made sense because it corresponded to the Queen of Spades theory and other reasons for uncertainty about banks’ balance sheets. At the time however, many traders and monetary officials thought it was mainly a liquidity problem.
To assess the issue empirically, we looked for measures of risk in these markets to see if they were correlated with the spread. One good measure of risk is the difference between interest rates on unsecured and secured interbank loans of the same maturity. Examples of secured loans are government-backed Repos between banks. By subtracting the interest rate on Repos from Libor, you could get a measure of risk. Using regression methods, we then looked for the impact of this measure of risk on the Libor spread and showed that it could explain much of the variation in the spread. Other measures of risk gave the same results.
The results are illustrated in Figure 8 which shows the high correlation between the unsecured- secured spread and the Libor-OIS spread. There seemed to be little role for liquidity. These results suggested, therefore, that the market turmoil in the interbank market was not a liquidity problem of the kind that could be alleviated simply by central bank liquidity tools. Rather it was inherently a counterparty risk issue, which linked back to the underlying cause of the financial crisis. This was not a situation like the Great Depression where just printing money or providing liquidity was the solution; rather it was due to fundamental problems in the financial sector relating to risk.
But this was not the diagnosis that drove economic policy during this period. While it is difficult to determine the diagnosis of policy makers because their rationales for the decisions are not always explained clearly, it certainly appears that the increased spreads in the money markets were seen by the authorities as liquidity problems rather than risk. Accordingly, their early interventions focused mainly on policies other than those which would deal with the fundamental sources of the heightened risk. As a result, in my view, the crisis continued.
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