Mythical Creatures: Unicorns and Libor

OK. I confess. I can’t take it any more. I vowed to stop picking on LIBOR and the British Bankers' Association. But like a smoker who can’t kick the habit I can’t stand it anymore; I have to write about LIBOR.

LIBOR has been in the news for the last few weeks and is being touted as “proof” that the short term credit markets have seized up. Last week’s news that CP rates have narrowed while LIBOR rates have widened should cast a little suspicion on the LIBOR claims. After all, CP rates are real and LIBOR rates are estimated (and without any real oversight).

LIBOR represents the rates that the 16 banks that make up the U.S. dollar LIBOR panel might lend to each other on an unsecured basis. But it isn’t the rate that they actually lend to one another, it is just the rate at which they might do business with each other. It is a kind of “imaginary rate” that is like the unicorn. It isn’t real.

Now I won’t suggest that there isn’t a credit crisis or that the money markets haven’t been constipated. I only wonder why most floating rate debt in the U.S. is based upon an imaginary interest rate, set in London, without any oversight and without legal protections against collusion or intentional manipulation. There are plenty of good home grown indexes that reflect real market conditions that could be used as the index rate for floating rate loans. These interest rates include Treasury rates, Federal Home Loan Bank rates, the Federal Funds Rate, the Discount Rate or a composite commercial paper rate.

But still, every morning the free world breathlessly waits for the British Bankers Association to declare LIBOR. Some economists have started writing that monetary policy should be focused on getting LIBOR to fall. They don’t understand that trading in LIBOR just doesn’t exist, and since it doesn’t exist, monetary policy can’t focus on getting LIBOR down. Just to be clear, I hope monetary and other government policy successfully targets interbank lending and stops the hoarding of cash by banks.  But targeting LIBOR…give me a break.  It is like trying to trap a unicorn. 

The LIBOR setting process reminds me of Groundhog Day when a large rodent comes out of his cage and adults pretend that it has predicted the weather.  It makes good theater, but who believes that a groundhog can predict the weather? 

Don’t believe me. Take a look at what others are saying about LIBOR.

• Nouriel Roubini on 9/26/08 wrote “There are no real term funding markets except for central banks. The Libor is meaningless.”
  
• Eric Salzman on 10/1/08 wrote “We have to caution that when we talk to funding desks, LIBOR has been a somewhat fictional rate that member banks phone in to the British Banking Association (”BBA”).”
  
• On 10/7/08 Bloomberg reported that the IMF has starting criticizing the mechanism for determining LIBOR when it “urged an overhaul” of LIBOR.
  
• Felix Salmon wrote in Conde Nast Portfolio.com on 9/26/08 “…Libor is an indicative rate: it’s the rate at which banks would lend to each other, if they were lending. If they stop lending, they still need to report some interest rate to the Libor committee. But it might well bear very little relation to banks’ cost of funds in the real world…”
  
• And, on 9/25/08 Donald MacKenzie wrote a long article about the Importance of Libor in the London Review of Books (with some unusual spelling in his article, after all he is British). Mr. MacKenzie wrote “Judged by the amount of money directly dependent on it, the British Bankers’ Association’s London Interbank Offered Rate matters more than any other set of numbers in the world. Libor anchors contracts amounting to some $300 trillion, the equivalent of $45,000 for every human being on the planet. It’s a critical part of the infrastructure of financial markets but, like plumbing, doesn’t usually get noticed. Only a handful of economists, and no other academics, have ever looked in any detail at Libor, and even the financial press didn’t show much interest in how Libor is calculated until this spring, when there was sharp controversy over whether these crucial numbers could be trusted.
  

  The calculation of Libor is co-ordinated by just two people, who work in an unremarkable open-plan office in London’s Docklands. I watched the process, which seemed utterly routine, a couple of years ago. Just after 11 a.m. on every weekday that’s not a bank holiday, traders at leading banks send in their estimates of the interest rates at which their banks could borrow money.
  

  …if Libor suddenly became unavailable, large parts of the global financial system would be paralysed. The 150 numbers constitute the dominant global benchmark for interest rates. The rates on borrowing, amounting to around $10 trillion (corporate loans, adjustable-rate mortgages, private student loans and so on), are pegged to Libor. For instance, the level of Libor determines the monthly payments on around half of the adjustable-rate mortgages in the US: rates are set as Libor plus a fixed margin, and are reset periodically as Libor changes.
  

  …In a financial world dominated since 1945 by the US, it’s striking that the global benchmark is a set of London rates.
  

  …a Libor input is what a bank could do, not what it has done. So judgment is involved. A bank might not have borrowed anything in the minutes before 11 a.m. Deals for longer than overnight are intermittent, and there is little borrowing at some of the time periods involved, such as 11 months. ‘Reasonable market size’ is deliberately not defined exactly: it will vary from currency to currency and according to time period and market conditions. The need for judgment is why the information provided by brokers is important to the calculation of Libor. It helps a bank’s traders to estimate the rate at which they could borrow money, even if they’re not trying to do so.
  

  …Much of the most vocal criticism of Libor has come from the US, and has focused on dollar Libor – especially three-month dollar Libor, the rate used more than any other in the swaps market. Some seem unhappy that the benchmark dollar interest rates are set in London just after 6 a.m. New York time, when traders are only starting to arrive at their desks, and that the US dollar Libor panel contains only three recognisably ‘American’ banks.
  

• On 10/10/08 Eric Salzman wrote “Three-month Libor, the rate banks supposedly lend dollars to one another, rose over six basis points to 4.82%.  The worst part is, that rate is a piece of fiction right now.  That is the average rate that sixteen banks phoned in to the British Banking Association (BBA).  The take out the top four and the bottom four and average the middle eight.  Banks have been faking this one for about a year now.  The truth is no one is lending to anyone right now.  The rate might as well be 10%.”
  
• And, on 10/11/08 Yves Smith wrote “…Libor is the benchmark for the “real economy” to get a loan. Libor is written into contracts and we have no good substitute. If Libor is screwed up, then the real economy pays because it needs Libor to get a loan.”
  

Of course, I have written about LIBOR a few times [1,2,3,4,5] and even had the British Bankers' Association directly comment on my posts.

Comments

[User 265729:]

Mythical Creatures: Unicorns and Libor and Western Economies

2008 Oct 14 01:50 PM

[Rakesh Saxena:]

Excellent, brief explanation of Libor.

2008 Oct 14 03:02 PM

[Brian Mairs:]

Well now we know what your scrapbook looks like. But it is incomplete.

By merely quoting Bloomberg you missed a few rather important bits from that IMF report, such as:

“Although the integrity of the U.S. dollar LIBOR fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar LIBOR remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding"

and, later:

"BBA proposal to introduce more aggressive scrutiny of individual bank contributions is still welcome, as it should improve the accuracy of the LIBOR calculation by, potentially, expanding the panel of contributing banks, and increasing incentives to submit accurate funding rates while maintaining transparency."

You can read the full document for yourself at: www.imf.org/external/p...

And that Salzman quote is more than a bit suspect too: that's certainly not how BBA LIBOR is calculated!

So we at the BBA repeat: our commitment is to providing the most accurate and transparent benchmark we can. Much of the criticism you repeat here is not criticism of LIBOR, but of the extreme volatility of the interbank market. Criticising a benchmark because of its market's erratic behaviour sounds to us a bit like shooting the messenger of bad news.

Our invitation to you to discuss any of these matters remains open - we remain anxious to explain how, and why, BBA LIBOR continues to be relied on by so many lenders as a true benchmark of money market activity.

2008 Oct 15 06:25 AM

[selene:]

Mr. Mairs, I'd be interested to know the methodology, if it's not what Erik Salzman posted. Is it posted somewhere, maybe on BBA web site?

2008 Oct 15 12:39 PM