Financial Risk Manager Part 1

Explanation

During the 2007-2008 financial crisis, interbank market interest rates (particularly LIBOR) rose sharply relative to Treasury bill rates due to:

Key Factors:

• Bank Losses: Banks incurred significant losses from mortgage-backed securities and other investments
• Structured Investment Vehicle Uncertainty: Off-balance-sheet vehicles, conduits, and structured investments required unexpected capital injections
• Funding Uncertainty: Each bank faced increased uncertainty about its own funding needs
• Counterparty Risk: Banks became wary of lending to each other due to similar financial vulnerabilities across the banking system

Why Option B is Correct: The combination of actual losses and uncertainty about future capital requirements created a liquidity crunch in the interbank market. Banks became reluctant to lend to each other, driving up LIBOR rates significantly compared to the relatively safer Treasury bill rates.

Why Other Options are Incorrect:

• A: The Federal Reserve's actions were aimed at stabilizing markets, not directly causing the interbank rate spike
• C: Geographic scope differences weren't the primary driver of the rate divergence
• D: While mortgage demand affected bank profits, this wasn't the direct cause of the interbank rate spike relative to Treasury rates

The crisis revealed systemic vulnerabilities in the banking system's interconnectedness and reliance on short-term funding markets.