The Market Corner: The Month in Review "Libor"
By Filippo Lecchini
We have all heard a lot about the London Interbank Offered Rate (LIBOR), particularly in the years following the financial crisis, as it turned out it was being manipulated, but how many know how it is calculated and what it is actually used for?
For starters the LIBOR is not just one rate, as several maturities and currencies are involved, but rather 150 different rates. Here is how the actual calculation works. More than a dozen of the largest banks estimate, as they deem appropriate, what it would cost them to borrow money in a certain currency and for a certain duration. So for example for rates in dollars JP Morgan, UBS, CITI and BOFA are part of the panel. They submit their estimates every morning to Reuters which, under the supervision of the British Bankers Association, is in charge of the calculations. The four highest and the four lowest entries are discarded as outliers, and the remaining ones are averaged to get the published rate. Far from a scientific process, the rate calculations are rather rudimentary, although more complexity might be hiding in each bank’s process to estimate a rate. It’s not hard to manipulate, especially if any of the actors collude on their entries.
The LIBOR, the rate at which banks can borrow from each other, is one of the driving factors in determining access to credit all over the world. Since January 1, 1986, when the daily publication began, it became a benchmark for all sorts of loans like mortgages, cars, student loans, credit cards or margin loans. The rates are often determined as LIBOR plus a markup to address relative risk. Whether people are aware or not LIBOR affects almost every aspect of one’s financial life, particularly in the United States where credit is more available and prevalent than in most other countries.
With all that being said, it should come as no surprise that the stark contrast between the simplicity of the calculations and the importance and pervasiveness of LIBOR has come under severe scrutiny from all parts. Different players in different industries as well as governments and regulators around the world have expressed concerns and advanced proposals to replace it.
The recent manipulation scandal certainly highlighted how the methodology is far from robust and vulnerable to collusion and strategic behavior, even without illicit conduct. With widespread consequences a new scandal would be hardly justifiable, and most likely would trigger some sort of credit crunch and heightened regulatory action. And then there is the more technical problem, pricing risk, which is possibly even more pressing. Based on the computation described above the bank with the highest rate will be excluded as an outlier from averaging so even if we believe that banks‘ estimates are meaningful, the riskiest entity by definition will not be charged enough.
There are many proposals out there on what the alternatives should be and they are different in different countries, but moving from some sort of survey system to something “observed” in a market transaction, a yield from a Treasuries auction for example or anything that comes from the interaction of demand and supply, might be preferable as more conducive of efficiency and truth telling.
The LIBOR as we know it might not have too much time left, but transitioning to anything else will not be quick or painless considering how extensively is used.
August is recess time for governments around the world but the fall, just around the corner, will bring policy back in focus. In the US healthcare is still an open issue, but an even bigger one will be tax reform.
The July employment number was better than expected, and we will see if the August report to be released on September 1st will show a persistent positive trend. The FED meets on September 19-20 and questions about a possible third rate hike in 2017 will be on everyone’s mind.
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