Some Thoughts on Libor: A Market based Solution
Libor is giving derivatives a bad name.
The London Interbank Borrowing Rate (Libor) and its calculation are subject to worldwide investigation. In fact, one bank has already paid over $450 million to settle rate manipulation allegations. Others are being investigated and may be implicated. Currently, estimates of damages resulting from the scandal range from $8 billion to $176 billion.
Libor is an interest rate at which banks will lend money to each other for different time periods (i.e. Overnight, 1-month, 3-months, in different currencies (e.g. the U.S. dollar, Euro etc.). The most popular is the dollar-based Libor. Libor is important benchmark for interest rates on mortgages, credit cards, swaps and the multi-trillion dollar financial derivatives industry including corporates and state and local governments. An accurate Libor has huge implications on our everyday lives. But there is a big problem with how we determine this rate.
Libor is an estimated rate and not an actual rate.
The current method to determine the dollar-based Libor involves 18 banks submitting their estimated rates, i.e. the rates they will be willing to lend to other banks for a given time period, to the British Bankers Association (BBA). The BBA eliminates the outliers (the bottom and top four estimates) and averages the remaining. Thomson Reuters then publishes this estimate as the official Libor rate. Herein lies the crux of the problem. As banks are only required to submit estimates that are not based on actual transactions, there is ample room for manipulation and collusion. In other words, the banks are not required to put money where their mouths are. While there is a growing consensus to move towards a transaction-based system, no real framework has been put forth. So here’s a market-based solution.
The 18 banks would be required to submit their Libor offer rates and a dollar amount they would lend to each other through a regulated clearing corporation. This requires them to back their offers with actual transactions as opposed to hypothetical ones. While this is a step in the right direction, it doesn’t prevent collusion. To address this, this proposal requires banks to submit an additional schedule of interest rates with the amounts they would be willing to borrow and lend at rates above and below Libor.
Here’s a simple example. If a bank submitted a Libor offer of 1% and concluded that a reasonable amount at that rate was $10 million, then they would be required to lend that amount to a qualified borrower. The participating bank would also be required to offer increasing amounts as the rates go higher- such as $25 million at 1.25% and $50 million at 1.5%. If the real rate is 1% then they have a perfect arbitrage borrowing at Libor and lending at the higher rate. If they had colluded to set the rate too low they would be penalized by lending a lot of money at an artificially low rate. They might also be required to submit rates below Libor at which they would borrow. This would have the same effect if banks colluded to set the rates at an artificially high rate. In summary, two things are readily apparent from the above mechanism. First, the requirement to lend at the submitted rate keeps a single bank’s estimate honest. Second, the requirement to lend (or borrow) at rates higher (or lower) than Libor prevents a group of banks from colluding with each other.
One reaction may be that no bank will be willing to borrow or lend based on its own estimates. If so, then maybe Libor isn’t a real benchmark and should not be used to set interest rates on hundreds of trillions of dollars of debt. Even if that is the case, there are still other market-based ideas we should try.
This above proposal is not as far-fetched as it seems. The Federal Reserve Bank of San Francisco used to publish an average deposit rate for banks in that district. Banks and savings and loan associations used this as a benchmark for variable rate mortgages. The system did not suffer from manipulation and worked well.
Moving Libor to a market-based, regulated and transparent system would benefit both bankers and consumers. The case is best demonstrated by how well regulated exchanges and their clearinghouses function worldwide. Every day, these exchanges clear over a trillion dollars’ worth of transactions for buyers and sellers. They create an enormous amount of value by facilitating price discovery and risk mitigation for products like government debt, mortgages, transportation, food and the environment. By bringing many buyers and sellers together in a centralized marketplace, an exchange lowers the costs of doing business for market participants. This results in benefits such as more affordable housing, lowered food prices, and access to credit for small businesses. The impact that regulated and transparent markets have on the lives of millions worldwide is both positive and tangible.
Moreover, exchanges performed flawlessly during the Great Recession of 2007-2008. Unlike other financial institutions, no exchange required a single penny of bailout money. Instead of increasing risk or market volatility, they provided effective risk management tools. For these reasons, the regulatory and clearing framework of exchanges is a viable model for Libor- the latter can begin by disseminating continuous reporting and data for the benefit of market participants and national regulators alike.
This fall the British Bankers’ Association is convening to determine how to change the current system. Consumers and investors stand to benefit from a market-based approach to Libor.
About the author :
Dr. Richard L. Sandor is the author of “Good Derivatives: A Story of Financial and Environmental Innovation” published by John Wiley and Sons and a Lecturer in Law and Economics at the University of Chicago Law School.