What Are Reference Rates For?

IMF Working Papers, January 27, 2017

Source details

Title: What Are Reference Rates For?
Author: Divya Kirti
Publication date: January 27, 2017
Publication type: IMF Working Papers
Central question: What is the precise role of reference rates, and why does it matter if LIBOR was manipulated?

The paper analyzes the use of reference rates in floating-rate loans and interest-rate derivatives within the context of lending relationships.
The author develops a simple framework combining maturity transformation with three key frictions which generate meaningful funding risk and a rationale for risk management.
Reference rates like LIBOR mitigate contractual incompleteness, facilitating management of funding risk.
As bank funding costs move with bank credit risk, it makes sense for the reference rate to have a bank credit risk component.
Manipulation can add noise, reducing the usefulness of reference rates for the purpose of managing funding risk.

Reference rates serve to reduce contractual incompleteness in floating-rate contracts and interest-rate derivatives.
Including a bank credit risk component in reference rates is rational when bank funding costs correlate with bank credit risk.
Manipulation of reference rates undermines their usefulness by introducing noisy signals into contract repricing and hedging.

Subject: Banking, Credit, Credit risk, Financial institutions, Financial regulation and supervision, Financial services, Hedging, Interbank rates, Loans, Money
Keywords: Credit, Credit risk, Europe, floating rate, Global, Hedging, Interbank rates, interest rate risk, interest-rate derivative, Loans, reference rate, Reference rates, risk tolerance, total utility, WP

What are reference rates for?
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