Libor Interest Rates

Abstract

This paper presents a dynamic general equilibrium model that disentangles interbank interest rates from interest rates on government bonds. Firstly, I explicitly identify the externality in the financial sector that explains the use of cash in the portfolios of financial intermediaries. Cash provides insurance for the interest rate used to finance loans. However, when a financial intermediary decides his level of insurance, he ignores the negative effect of his decision on the remaining financial sector. It is shown that the positive spread between interbank rates and treasury rates is the leading variable that drives the money market. The spread has to increase when financial intermediaries desire less cash than the cash available in the economy. Similarly, the spread decreases when there is less cash in the economy than desired by financial intermediaries. Secondly, general equilibrium implications are analyzed. The externality creates an ex-ante distortion in the financial sector. As a result, borrowing interest rates have to increase relative to lending interest rates. The analysis is developed in a model where there are private investors, financial intermediaries and a government. The model is simple enough to allow close form solutions. I identify the role played by interbank rates that prevents them from reflecting a pricing kernel at which the real economy is willing to transfer cash flows over time, thereby compromissing the use of Libor interest rates in valuation. Additionally, an increase in expected inflation exarcebates the externality identified in this paper. As a consequence, expected inflation increases the equilibrium costs of financial intermediation. The result is an increase in real interest rates and an economic slowdown.