Inconvenient truths about Libor


We may well see more heads roll at major banks before the scandal surrounding Libor is over. But some senior members of the international financial community are increasingly wondering about the future of Libor itself.

As one senior international regulator put it to me: "The benchmark is broken. It needs to be fixed. Or perhaps it will just go the way of the dodo. The world has changed."

That's because the scandal has shed light on an inconvenient truth about these interbank rates which are used to determine the price of so many hundreds of trillions of dollars worth of global financial contracts.

That inconvenient truth is that even when London Interbank Offered Rates are not "fixed", they may still not bear very much relation to reality - because banks are not actually offering much unsecured money to each other at all.

This has been an open secret among bankers and regulators since the start of the credit crunch in 2007. What any outsider would find surprising is that until now, neither the Financial Services Authority (FSA) nor the Bank of England have really made it their business either to replace Libor - or make it more accurately reflect reality.

Interestingly, this is what the US regulator, the Commodities Futures Trading Commission (CFTC), has tried to do in its settlement with Barclays. If and when it ends its investigations of other banks, it will presumably try to do the same with them.

We know that the British bank has been fined £290m ($450m) by the Financial Services Authority and the CFTC for making false claims about the rate at which it was borrowing from other banks - either to make profit or to protect Barclays' reputation at a time when it was seen to be paying more than others to borrow.

There has been less focus on the "undertakings" which Barclays was also forced to make to the CFTC, about how it would calculate and report its interbank borrowing rates in future.

These come into force 14 days from the signing of its agreement with the US regulator and will require the people reporting the bank's cost of borrowing for the BBA to base that report on actual transactions that Barclays has been involved in - in other words, on actual loans it has obtained or made on the wholesale market.

If Barclays hasn't, in fact, obtained or offered such loans, its new rules say it must calculate the rate on the basis of other secured loans that the bank has been involved with (i.e. loans backed by collateral). If there haven't been any of those either, they have to refer to similar transactions that other banks have been involved in which Barclays folk have themselves observed in the market - and so on and so on.

The point is that somewhere along the line, there has to be an actual transaction involved - and the system for deriving the Barclays interbank borrowing rate from those transactions has to be entirely transparent.

You might wonder why that is worth an official "undertaking" in a legal settlement with the US regulator. After all, isn't that what the Libor rate is supposed to reflect - the rate at which banks are able to borrow and lend from each other?

The answer to that question is yes, that is what it is supposed to be. The trouble is that it does not - cannot - mean that in an environment in which banks are finding it very difficult to get unsecured loans from anyone for any length of time.

As we keep hearing, that was the situation for large parts of 2007, 2008 and 2009, when some of the "fixing" and attempted manipulation of Libor at Barclays was taking place. But, as Robert Peston often reminds us, it is also true of many banks right now - especially across the Channel.

Many banks on the continent - in so called "core" economies like France as well as Spain, Portugal etc - cannot really borrow on the interbank market at all at the moment.

In the City, the borrowing by banks for more than one week is almost entirely happening on a secured basis. Collateral is king.

Many banks in the eurozone are almost entirely dependent on the European Central Bank (ECB) for day-to-day liquidity. And since the ECB started its long-term refinancing operation (LTRO) programme last November, they have been getting quite a lot of longer term funding from that source as well.

And yet, throughout this period, the Euribor - the Euro Interbank Offered Rate, also caught up in the Barclays manipulation scandal - has been faithfully reported, day in day out, by more than 50 European banks. You have to wonder what those rates actually mean.

True, included in that list of 50 are some major global banks who are unlikely to have much trouble borrowing on the wholesale market: Deutsche Bank, for example, and JP Morgan. But you also have banks like the National Bank of Greece, Allied Irish Bank, La Caixa Barcelona and Societe Generale.

We're not just talking overnight borrowing here. The Euribor rates that are reported include the cost of borrowing for anything from one week, to an entire year. If you ask banking industry insiders how many of those 50 banks are actually getting unsecured loans for a year - or even one month - on the wholesale market they are quite likely to laugh in your face.

So, maybe the Euribor and Libor rates correspond to something, but we know for a fact that they do not always, or even usually, correspond to an actual transaction. Nor, if you look at the guidelines for setting Libor on the British Bankers' Association (BBA) website, are they required to. Banks merely have to report the rate at which they "could" borrow funds before 11am, were they to decide to do so. How, exactly, each bank determines the rate is largely up to them.

The CFTC settlement says Barclays had "no internal procedures and controls" determining how the Libor rates were calculated. The BBA does not seem to have had any problem with that.

As it happens, the strangeness of this situation was captured very well by Sir Mervyn King in testimony to the Treasury Select Committee in late November 2008, when he had this to say about Libor.

"It is in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content. I think it is convenient, very often, for people to justify what they do for other reasons, in terms of Libor, but it is not a rate at which anyone is actually borrowing. It is hard to see how it can actually have much of an impact."

And yet, despite their inherent fuzziness and lack of "significant operational content", despite the lack of formal checks on banks' internal procedures for coming up with these rates, Euribor and Libor are the benchmark for pricing transactions worth trillions of dollars. US dollar Libor, for example, is the basis for the settlement of the three-month Eurodollar futures contract, which had a traded volume in 2011 with a notional value of $564 trillion, according to the CFTC.

Many of you will find all of that pretty odd - and pretty shocking. I know most economists would.

We are all understandably interested in what Bank of England deputy governor Paul Tucker and other senior officials may or may not have said about the Libor to Bob Diamond or other bankers, at the height of the credit crunch in 2008.

But, perhaps we should also be asking why those senior officials and regulators continued to allow Libor to play such an iconic role in global financial contracts - when even the governor of the Bank of England knew quite well that they did not paint a remotely accurate picture of reality. Even when everyone was playing by the rules.

Stephanie Flanders, Economics editor Article written by Stephanie Flanders Stephanie Flanders Former economics editor

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  • rate this

    Comment number 226.

    221 BDFM - not a bad idea but perhaps you miss the point. Its convenient for the market to have a base measure of the base cost of money to banks. If the majority of the liquity is being created by the central banks interbank is pretty meaningless however its reported ?

  • rate this

    Comment number 225.

    The whole establishment is in it together. Barclays Board supported the CEO last weekend, who is on the Board but Chairman of the National Audit Office. How does that work???

  • rate this

    Comment number 224.

    The official BBA Libor website states "Every panel for the 10 bbalibor currencies, each ranging from 6 to 18 contributors..." but then goes to show the 'trimming methodology" for 18 Contributors down to 7. So can contributory panels for individual currencies consist of 6 members? If so, whats the trimming methodology in these instances? Are any submitted rates discarded?

    Have I got this right?

  • rate this

    Comment number 223.

    An inconvenient truth : The banks are bankrupt, they always have been.

    As a collective they loan out more money than they have based on nothing but debt.

    When the debt becomes worthless so too does the money.

    It is this that leads to all the other shenanigans we are witnessing

  • rate this

    Comment number 222.

    220. Happyineuroland
    214 Jammydodger

    If it were false accounting, would Barclays not be prosecuted??

    I would expect Barclays to argue it was not material.

    You said trillions- is that not not material? And yes, Barclays should be prosecuted, with those traders involved. If they aren't, then we do not live in a country where the rule of law prevails.

  • rate this

    Comment number 221.

    I see a potential solution as follows:
    Banks must report 2 rates - firstly the rate at which they are offered funds either directly from another bank of via brokers and secondly the rate that the quoting bank is offering funds to the market. Then take an average of those 2 rates and discard the upper and lower outliers. Also, compel quoting banks to deliver proof of the rates that they submit.

  • rate this

    Comment number 220.

    214 Jammydodger

    If it were false accounting, would Barclays not be prosecuted??

    I would expect Barclays to argue it was not material.

  • rate this

    Comment number 219.

    #218 hm "in 2008 the world...would have been in trouble!"

    Here you make a terrible mistake - a mistake that is causing the Depression.

    Fiddling the LIBOR rate HID but could NOT FIX the underlying problem.

    The banks MUST die so that the capitalist system can correct itself. The longer we delay (the more QE we waste!) the worse the situation gets.

    No recovery till rates rise to reflect risk!

  • rate this

    Comment number 218.

    Fact is, if LIBOR rate (as it is / was then calculated) 100% accurately reflected the state of inter-bank lending in 2008, the world's financial systems (for which LIBOR an integral yard-stick) would have been in trouble!

    Obviously some sort of auomatic registering of I-B lending (certified at each end) is needed. But maybe add in some features (ave. over preceeding 100 days?) to avoid jolts?

  • rate this

    Comment number 217.

    The point is that the world links $ trillions to an unregulated, unchecked value (LIBOR). Heard that before? Oh yes, credit ratings and MBS. all those AAA ratings for junk. instead of asking "does this really matter or make it illegal", let's find the next crisis. FX rates anyone? WM Reuters use a similar to process LIBOR. Others calculate cross rates passed off as real rates. look here someone!

  • rate this

    Comment number 216.

    A judicial inquiry could damage the reputation of this country which is probably why the government won't allow it. Strange Labour want this

    Not strange at all. A judicial enquiry probably won't report until after the next general election.

  • rate this

    Comment number 215.

    A judicial inquiry could damage the reputation of this country which is probably why the government won't allow it. Strange Labour want this rather than the whitewash a parliamentary inquiry will deliver
    Needed though. Banking is global and this country will not be trusted unless there is a proper examination and clean up if necessary.

  • rate this

    Comment number 214.

    203. Happyineuroland
    4TH JULY 2012 - 22:58
    If I worked at Barclays and could make trlllions by submitting a 3 instead of a 4 on a piece of paper I would do so.

    Under what law is this a criminal act?
    I know it's hard to understand, but those trillions come from somebody else. Falsifying a document for financial gain is called false accounting and fraud. All clear now?

  • rate this

    Comment number 213.

    It's surprising that major corporations are prepared to pay multi-million packages to top executives who suffer from defective memories. I would have thought that this affliction might hamper them in the efficient performance of their duties. Isn't there a large pool of people available who have excellent memories?

  • rate this

    Comment number 212.

    I recall that banks used LIBID (London Interbank Bid Rate) as the basis for setting interest rates paid on corporate deposits. LIBID was usually taken to be 1/8 less than LIBOR for the relevant period. Where LIBOR was artificially lowered it certainly would have had an impact on the actual returns those corporates received.

  • rate this

    Comment number 211.

    Well based on your somewhat dismal logic all "righties" are criminal lying fraudsters, you can't have it both ways.

  • rate this

    Comment number 210.

    It would be useful to have an in depth investigation into the Rating Agencies. The questions that need to be answered include what percentage is owned by the banks and the make up of their boards and executives. From the European point of view they seem very quick to downgrade countries ratings other than the US which has the largest debt of any country. Answers on a devalued greenback.

  • rate this

    Comment number 209.

    With Bankers like everything else it is the quality and value of the lies you tell. Truth is something to ridicule and an irritation in the Banking "business" Banking spivs "flog" things, time to flog the "spiv things"

  • rate this

    Comment number 208.

    The technical term for normal making it up is: Sentiment
    The technical term for recent making it up is: Fraud

    The technical term for deriving normal Libor is: Consensus / Fair Value
    The technical term for recent Libor fixing is: Concerted manipulation

  • rate this

    Comment number 207.

    Good article. So now we know - they are all just making it up. Not only Libor but everything to do with "banking" including their own view of their abilities. Witness - the billions and billions that have been lost in poor judgement on acquisitions, property loans, corporate bad debts and product mis-selling. A review ? Let's have some action against incompetents


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