A Simple Interest Rate Model with Unobserved Components: The Role of the Interbank Reference Rate

Muto, Ichiro (2012): A Simple Interest Rate Model with Unobserved Components: The Role of the Interbank Reference Rate.

Abstract

In this study, we theoretically investigate the potential role of the reference rate in stabilizing or destabilizing an interbank market with an environment where individual banks cannot fully identify the nature of underlying shocks affecting their interbank transactions. We show that a noise-free reference rate based on a sufficient number of sample transactions can help to make the market interest rate less volatile, whereas the stabilizing effects of the reference rate are significantly reduced if the reported interest rates contain some noisy components. Nevertheless, by increasing the number of sample transactions reflected in the reference rate, the adverse effects of the noise can be mitigated (or eliminated) provided the noise is idiosyncratic to individual transactions. However, if the noise is common to multiple transactions, then the adverse effects of the noisy reference rate cannot be reduced simply by increasing the number of sample transactions. This suggests that the noise in the interest rates reported by just a few of large banks can end up making the entire market more volatile, thereby impairing the transmission mechanism of monetary policy.

• Item Type: MPRA Paper
• Language: English
• Keywords: Interbank Market; Reference Rate; LIBOR; Imperfect Information; Financial Stability; Transmission Mechanism of Monetary Policy
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy

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