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The World after LIBOR - Part I: How to fix OTC Fixings

by Werner Broennimann

"[LIBOR] is, in many ways, the rate at which banks do not lend to each other, [...] it is not a rate at which anyone is actually borrowing..." - Mervyn King, Governor of the Bank of England
There have been a number of major and minor headlines around LIBOR[1][2] and its relative ISDAFIX in the past. As with the issues around the Global Financial Crisis, the big banks have not covered themselves in glory. But I am trying to make the case that putting the whole blame on evil bankers falls short of any comprehensive explanation of what happened, why and what can be done to avoid a repetition of such mistakes.
After the LIBOR scandal and subsequent investigations regulators reached a consensus that the current setup of LIBOR is not working well. I would argue that the deficiencies in the fixing process and in the underlying market were creating an environment that made cheating both very easy and relatively hard to prove. Given what we know about how incentives work and how banks operate, these deficiencies need to be addressed to avoid a repetition of such scandals.
LIBOR is actually not that old. The London Interbank Offered Rate came about in the ‘80s as there was growing demand for “an accurate measure of the real rate at which banks could borrow money from each other” [3]. The initial definition was “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?” [3], this was changed in 1998 to “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” [3]. Both of these definitions have the advantage of being relatively straightforward, short and easy to implement but they are also quite hard to verify and depend on honest cooperation from the banks. For the growing money market and derivatives market back in those days this was likely a quick solution that worked well. But this simple survey set up (also in the refined definition from ‘98) would cause more headache later on.
Fast forward to 2006. Pre Financial Crisis the interbank money market was alive and kicking. Wholesale funding was cheap and popular and it was used extensively to fuel to capital intensive activities such as proprietary trading. The credit risk involved in unsecured lending was not a big concern as this was the Great Moderation. The LIBOR curves illustrate this quite well. In the final months before the crisis from 2006 Q4 until 2007 Q4 the difference between 1 month LIBOR and 12 months LIBOR was less than 0.10%. This was partially a reflection of the very flat USD swap curve, but also of a very benign credit environment, as money market transactions involve unsecured lending. All things equal, there is a higher credit risk in such trades with 12 months tenor than with 1 month tenor and 0.10% seem like a rather low compensation for such risk. In January 2009 this spread went up to more than 1.50%, in mid May 2013 it was around 0.50%.
After the Lehman default no bank really wanted to lend to other banks on an unsecured basis because of the involved credit risk. Unsecured interbank lending all but collapsed and liquidity was mainly provided by the central banks.
“...bbalibor is not necessarily based on actual transactions...” [3]. In this new Credit Crunch world the market, which LIBOR rates were meant to describe, had almost disappeared. But very significant amounts of rates instruments (including loans and mortgages) still referenced those rates. All of a sudden the drawbacks of the survey nature of LIBOR became more apparent.
Even with the best of intentions it is difficult to properly guess the rate of a (money market) trade that does hardly happen anymore. Gary Gensler, chairman of the US Commodity Futures Trading Commission, eloquently addressed the current issues with LIBOR: "It doesn’t make sense to base markets on fiction [...] governance structures alone cannot address the problems. You need [benchmarks] anchored in observable transactions".
When banks started to illegitimately set their LIBOR panel submissions at their convenience, they were facing two main incentives. First, submitting low rates to the panel would signal a low credit spread and hence good financial health of the institution. In theory the individual submissions are not meant to be public, but for example Barclays “...routinely made artificially low LIBOR submissions to protect Barclays’ reputation from negative market and media perceptions concerning Barclays’ financial condition...” [4]. Second, given that the banks' massive interest rate trading books are typically not completely hedged all the time, manipulating the rates in their favour could yield them sizeable profits very quickly. These manipulations, combined with collusion on rates submissions, eventually led to the LIBOR scandal as we know it.
I would not want to approve of the behaviour of the involved banks in any way, but we should realise that because of the defunct nature of LIBOR and the potential profits at stake, the situation was akin to asking the fox to guard the chicken.
More about the ISDAFIX investigation and potential remedies in Part II.
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[1] The full official name is British Banker’s Association London Interbank Offered Rate or BBA LIBOR
[2] Most of the points in this article also apply to EURIBOR (for EUR rates), TIBOR (for JPY rates), SIBOR (for SGD rates) and similar money market fixings around the world.
[3] http://www.bbalibor.com/explained/the-basics
[4] http://www.cftc.gov/PressRoom/PressReleases/pr6289-12
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