Why Central Banks May Never Allow LIBOR To Be Fixed


Photo: Peter Thal Larsen

U.K. investigator Martin Wheatley kicked off his study of one of the world’s most important benchmark rates—LIBOR—today with the publication of an initial discussion paper on how the rate might be changed to avoid manipulation.The London Interbank Offered Rate is the average interest rate at which the world’s largest banks say they can lend to one another, denominated in a variety of different currencies at different maturities. 

The LIBOR rate has become the centre of a scandal, after regulators revealed that banks could easily manipulate the rate.

One of the many suggestions that Wheatley and others have made for how to “fix” the rate is by making it dependent upon real transactions that happen between banks. Right now, banks submit estimates for the rate at which they can borrow, and Thomson Reuters (with the oversight of the British Bankers Association) compiles, sorts, and averages them after excluding outliers.

But the reality is that LIBOR and other similar rates now correspond so closely with rates set by central banks that they aren’t effective.

But first, a brief history of LIBOR and the markets it governs:

Before LIBOR, banks exchanged money with each other using certificates of deposit (CDs) issued by individual banks. In good times, investors began to think that all CDs were virtually risk-less. But because each bank actually had a distinct credit risk, this was obviously a faulty assumption. Ultimately, credit problems led Continental Illinois to withdraw from the CD market, compromising investor faith in the rest of the CD market.

The blossoming Eurodollar futures market (essentially, massive contracts between financial institutions to exchange money that are settled in LIBOR) provided an attractive, highly liquid alternative to the market for CDs. The system’s designers had to create a basis for money markets that wouldn’t collapse with a single bank, yet would also be flexible enough to reflect real lending rates.

“The miracle of the whole market is that you’ve constructed an amazing financial structure on an intangible idea,” Galen Burghardt, author of “The Eurodollar Futures and Options Handbook,” told Business Insider. Burghardt worked at the Chicago Mercantile Exchange—where Eurodollar futures were traded—just as these products were being established as the dominant securities in the world.

Burghardt revealed that the system’s creators did think about ways in which submitters could manipulate rates. “It was thought that a lot of these issues would be dealt with through market discipline,” Burghardt revealed, citing the fact that banks’ submissions are publicized.

“The challenge was trying to figure out a way to do it,” he added. “There wasn’t any right answer.”

In the financial crisis, banks began reporting falsely low lending rates because they had to. Banks’ credit risks are reflected in the rate at which they can borrow from counterparties, so market participants not versed in money market dealings began to speculate against a bank submitting a real but high rate versus those submitting an artificially low rate. Thus the LIBOR rate converged to an artificially low rate because submissions were resoundingly low for the purpose of banks’ survival, distorting markets (for good or ill).

As the crisis set in, LIBOR rates spiraled out of control, and central banks scrambled to adopt a slew of liquidity measures in order to lower the cost of lending once again.

Since then, the world’s central banks appear to have effectively co-opted control of banks’ lending rates. Monetary policy has become so effective at manipulating lending rates in order to ease or tighten monetary policy that, in periods of stability, the LIBOR rate effectively clustered around 14 bps higher than the federal funds rate.

Click to enlarge.

overnight libor versus effective fed funds rate

Photo: Simone Foxman/Bloomberg Data

The Federal Reserve and the world’s other central banks have good reason to want control of lending—the primary purpose of central banks is to impact lending via monetary policy, thus easing or tightening the supply of credit to the real economy.

That said, allowing central banks to control this so closely does remove the “invisible hand” that governs markets so well.

If regulators want to replace LIBOR, then they’ll have to effectively wrest it from the control of central banks. They will have to let lending rates rise and fall on their own to accurately reflect tensions in financial markets.

That’s not a power central banks are likely to give up so easily, particularly not when they are doing all they can to flood the system with cheap money and keep floundering economies alive.

“The real problem is a government that thinks it can solve it,” Burghardt remarked.

If you can help us better understand this, are connected with LIBOR and related securities, or are involved in any current investigations, please contact Simone Foxman at [email protected] or call +1-646-376-6016 (U.S.).

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