Monday, October 20, 2008
The London interbank offered rate ("LIBOR") is the rate at which banks offer to loan money to one another in London. As such, it is a key indicator of liquidity in the financial system. (LIBOR is also to determine rates on $360 trillion of financial products worldwide, from mortgages to company loans and derivatives).
The governments of the U.S. and Europe have been pumping trillion dollars into the system to increase liquidity. LIBOR has, in fact, been falling, which is a very good sign.
However, the question is whether LIBOR is being manipulated, or is falling on its own.
Of course, the fact that governments have been giving banks staggering sums of cash encourages the banks to loan some of that money to each other. That's not manipulation - its socialism. But that's not what this essay is about.
What I'm focusing on is actual fudging of the numbers.
As Bloomberg notes today:
The Bank for International Settlements said in March some lenders may have "manipulated'' rates to keep from appearing like they were in financial straits.The Bank for International Settlements is called the "central bankers' central banker", and so its opinion carries great weight.
Bloomberg carried the following quotes in May:
"The Libor numbers that banks reported to the BBA [the British Bankers Association] were a lie,'' said Tim Bond, head of global asset allocation at Barclays Capital in London. "They had been all along. The BBA has been trying to investigate them . . . ."
"Since the credit crunch, it's something that appears to have been manipulated,'' said Hahn, a former managing director at Citigroup.
Indeed, the central banks are now watching credit default swaps more than LIBOR as an economic indicator of the health of the economy. Is this partially because they know LIBOR isn't reliable?
As the Wall Street Journal explained in April:
In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the London inter-bank offered rate, known as Libor, is becoming unreliable...
Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates....
No specific evidence has emerged that banks have provided false information about borrowing rates, and it's possible that declines in lending volumes are making some Libor averages less reliable. But bankers and other market participants have quietly expressed concerns to the British Bankers' Association....
Questions about Libor were raised as far back as November... In a recent report, two economists at the Bank for International Settlements, a sort of central bank for central bankers, also expressed concerns that banks might report inaccurate rate quotes.....
In a recent research report on potential problems with Libor, Scott Peng, an interest-rate strategist at Citigroup Inc. in New York, wrote that "the long-term psychological and economic impacts this could have on the financial market are incalculable." Mr. Peng estimates that if banks provided accurate data about their borrowing costs, three-month Libor would be higher by as much as 0.3 percentage points....
In one sign of increasing concern about Libor, traders and banks are considering using other benchmarks to calculate interest rates, according to several traders. Among the candidates: rates set by central banks for loans, and rates on so-called repurchase agreements, under which borrowers provide banks with securities as collateral for short-term loans.
In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."
If banks manipulated LIBOR earlier to downplay how much trouble they were in, could they be manipulating LIBOR now to try to pretend that things are getting better and the the global economy is recovering?
If consumers thought the economy was recovering, they might buy more and borrow more, which means more profits for the banks. Therefore, the banks may have a very strong motivation for manipulating LIBOR.
I hope that the fall in LIBOR is real, but given the history of manipulating, we can't passively accept it without question.