What are reference rates for?

Abstract:

What is the precise role of reference rates? Why does it matter if LIBOR was manipulated? To address these questions, I analyze the use of reference rates in floating rate loans and interest rate derivatives in the context of lending relationships. I develop 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, in this context 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 this purpose.

Last updated on 10/25/2015