Institute for Financial Transparency

Shining a light on the opaque corners of finance


Banks vote on replacement for Libor

In the run-up to the financial crisis, the Libor interest rate became the most important rate in the financial world.  It was literally the price of money.

Libor was used as the basis for pricing bank loans including commercial and industrial, real estate and auto loans.  Not only that, it was the reference rate for interest rate swaps involving hundreds of billions of dollars.

Then came the financial crisis and the disclosure that Libor was manipulated by bankers for their personal profit (it was also manipulated during the crisis with the consent of central banks to make the banks look like they were in better financial condition than they really were, but that is a separate story).

Naturally, regulators and other market participants wanted to eliminate the ability of bankers to manipulate Libor.

The easy solution: require banks to disclose all of their funding transactions over the preceding 24 hours and let the market calculate Libor using these transactions.

Of course, the banks blocked this solution.  After all, if banks could provide transparency into their funding details, they could also provide transparency into the exposures on the asset side of their balance sheet as well as off their balance sheet.

So the bankers rapidly trotted out the notion of creating a new reference rate to replace Libor.  Of course their enablers, i.e. the financial regulators, leapt to support the idea of a new reference rate.

The financial regulators argued a new reference rate was needed because there weren’t enough trades done to insure Libor was always based off of actual transactions.

What the financial regulators failed to say was why there might not be enough trades.  The lack of trades reflects a combination of two factors.  First, the borrowing banks are opaque and banks that would lend money to the borrowing banks cannot determine if the borrowing bank will repay them or is solvent.  Second, central bank monetary policies, particularly QE, have reduced the need for banks to borrow from other banks.

Needless to say, these factors were conveniently swept under the rug and the search for a new reference rate commenced.  Bankers narrowed their choice down to two alternatives:

The two alternative rates under proposal in the United States are the Overnight Bank Funding Rate, an unsecured bank lending rate based on transactions in the fed funds and eurodollar markets, and a rate based on overnight lending in the U.S. Treasury collateralized repurchase agreement, or “repo”, market.

The repo rate won.

The only small problem with this rate is it is a fully collateralized overnight rate.  The transactions Libor is based off of are unsecured and extend from overnight to as long as one year.  The bulk of these transactions occur with maturities of 30 to 90 days.

Perhaps it isn’t such a small problem as the only similarity between a repo rate and a Libor rate is the use of the word “rate”.

There is no reason to expect rapid adoption of the new reference rate.  Until it is, financial markets will continue to rely on Libor and bankers will continue to rig the rate for their personal benefit.

In addition, the bankers were very successful in once again avoiding having to provide transparency.