The Myth of Fixing the Libor

15 january 2013

Sometimes modern finance has a great need for something, and so bankers invent products that appear to fill that need. When it turns out that the invention was actually something else entirely, people are shocked.

So it was a few years ago with senior tranches of asset-backed securities. Investors perceived a need for risk-free assets with floating rates, and Wall Street banks served up trillions of dollars worth of such paper — or at least they said they did.

So it is now with Libor — the London interbank offered rate — which not coincidentally was an important component of that other folly. That there was fraud based on made-up numbers is clear. That the system can be fixed is not.

But Martin Wheatley, Britain’s top financial regulator, has concluded Libor can be saved. “Although the current system is broken, it is not beyond repair,” he said in remarks prepared for delivery on Friday.

He may turn out to be overly optimistic. Libor is, and is likely to remain, a fiction. You can maintain the fiction, or you can embrace a much less palatable reality.

The Libor fiction began in the 1980s, when finance felt a need for a private sector, virtually risk-free interest rate to serve as a benchmark. Banks had learned that there was a big risk to making a long-term fixed-rate loan — the risk that market interest rates would rise and leave them with loans that were paying less than it was costing the bank to pay for the loan. Short-term loans could solve that problem, but at the risk that the borrower might be forced to repay at any time a loan that was taken out for a long-term project.

Enter Libor. A loan could be long term, but with a rate that periodically reset based on the cost of funds to banks. If a loan were priced at, say, three percentage points above the three-month Libor, the bank would be getting a reasonable risk premium, and would face no risk from changing market rates, since the interest rate would be reset every three months. The borrower would get long-term money.

There were two implicit assumptions in Libor. One was that banks were virtually risk-free, or at least that their risk was small and would not vary much over time. The other was that there was a way to actually calculate what the rate was. Both assumptions turned out to be wrong.

Libor rates are calculated each day by the British Bankers’ Association, a trade group that makes good money from licensing the use of Libor rates. Each day panels of banks tell the association the rate they will have to pay for unsecured loans at maturities ranging from overnight to 12 months. They do that for each of 10 currencies, including the United States dollar, the euro, the Swedish krona and the New Zealand dollar.

The scandal made clear that those reports were faked before and during the financial crisis by at least some of the banks. But what is not as widely appreciated is that there is substantial evidence that the deception goes on. Banks continue to report figures that strain credulity, both in their level and in their lack of volatility from day to day or week to week. The scandal might never have surfaced, or might have done so in a sanitized fashion, had bank regulators had their way. But the banks had the bad fortune that the investigation of it was spearheaded by the United States Commodity Futures Trading Commission, a market regulator that under Gary S. Gensler, the chairman appointed by President Obama, has changed from lap dog to bulldog. It had no institutional need to protect the banks, and it did not.

This week Mr. Gensler, testifying before a European Parliament committee, laid out the evidence that the deception continues, although he was nice enough not to put it in such stark terms. He noted the wide swings in the cost of credit-default swaps on debts issued by major banks, while those same banks were reporting that their costs of unsecured borrowing were varying hardly at all.

“It is critical that markets be able to rely on something that is credible and honest. The data in the market now strains that credibility,” Mr. Gensler said in an interview before Mr. Wheatley’s conclusions were announced. “History shows that something that is prone to abuse will be abused, and that even people of good faith can have a difficult time estimating when there are no observable transactions.”

In his testimony, Mr. Gensler noted that a competing indicator, known as Euribor, consistently came up with higher rates than Libor. In the middle of this week, the three-month United States dollar Libor rate was 0.36 percent. The similar Euribor rate was 0.61 percent.

Perhaps that can be explained by the Lake Wobegon effect, after the mythical town invented by Garrison Keillor in which all the children are above average. Libor asks each bank to give the rate at which it could borrow. Euribor, administered by the European Banking Federation, asks banks to give the rate at which they think the average bank could borrow.

These days neither number is based on real transactions, since there is virtually no interbank unsecured lending. Perhaps every bank believes it is above average.

Mr. Gensler says that a replacement for Libor should be based on observable market transactions, not subject to manipulation.

Mr. Wheatley evidently entered into his research having decided that Libor must be saved. Proving that Libor is “beyond repair” would not be enough, he said. There would also have to be “a better alternative” that already existed, and a way to make “an immediate and smooth transition.” It was obvious that the last two criteria could not be met.

His solution is to put a new group in charge of Libor and to slim it down by purging small currencies and most maturities. “This will reduce the current number of Libor reference rates — 150 — down to 20 where we are confident there is a real market to underpin the rates,” he said.

It will be interesting to see his evidence that such a market exists. He evidently knows there is not much of one. He would still allow banks to submit rates not based on transactions, but would make them disclose that fact. There would be new regulations aimed at forcing banks to be honest.

His conclusions seem to be based on the same kind of logic that got us into the mess in the first place. Without a benchmark, floating rate loans are impossible. We need floating rate loans. Therefore, there must be a good benchmark.

There is one sort-of real rate that has been discussed as a replacement for Libor: the overnight index swap rate. Don’t worry if that sounds like Greek to you. It is observable, but it is also based on the Fed funds rate set by the Federal Reserve. It is manipulated, in other words, but by the central bank. Using the swap rate would reflect the real world, more or less, but would not reflect the banks’ actual cost of funds. The creditworthiness of banks as a group, and of individual banks, will vary, sometimes drastically. Mr. Wheatley seems to have dismissed that idea out of hand.

The underlying problem is that the great desire for risk-free assets, and genuine risk-free interest rates, simply cannot be met in the real world. A major contributor to the financial crisis was that the financial engineers decided that you could take a basket of inherently risky assets — say, home mortgages — and treat it as if it were 70 or 80 percent risk-free. So senior securities backed by that basket would be rated AAA by the rating agencies, and would float based on Libor. Investors craved no-risk assets, and Wall Street obliged.

The bank regulators believed the fiction. Banks that owned AAA-rated floating rate assets needed to keep virtually no reserves on hand to back them.

We all know what happened. It turned out that risks were far greater than had been realized. Banks failed or were bailed out. Investors in AAA securities suffered major losses.

Libor was manipulated by bankers long before the financial crisis, and it is still based on calculations that have little basis in reality. Mr. Wheatley assures us that more regulation can deal with conflicts of interest. There will, he promises, be a “clear code of conduct” and “clear rules,” enforced by a regulator with “extensive powers.”

Pollyanna lives.