Interest Rate Pass-through and Risk

One of the most striking features of the financial crisis that began in the autumn of 2007 has been the associated upheaval in conventional interest rate spreads. In the UK, this is most frequently symbolised by the widening (and increased volatility) of the spread between 3-month Libor and the Bank of England's policy rate. This paper uses a vector error correction model to look at the way in which the recent crisis has affected a wide range of interest rate spreads. We look for changes in the coefficient on the policy rate (the 'pass-through') and at changes in the speed of adjustment to changes in the policy rate, since both are important for policy. We find, as others have done, that the conventional behaviour of almost all spreads is swept away after August 2007. By developing a model which incorporates measures of counterparty and liquidity risk, we show that market rates are now subject to additional influences but which, except for secured loans, still incorporate the effects of changes in the policy rate much as they did before the crisis. This contrasts with the widely-held view that the relationship between policy and money market rates in particular has been severely disrupted by the crisis. For secured loans, however, there is evidence that the mark-up has risen while at the same time the policy pass-through has fallen since August 2007. The same applies to deposit rates, albeit to a lesser extent, with the result that the sharp reduction in the policy rate since the end of 2007 has had a larger effect on deposit than loan rates, the subject of widespread media comment.