All Things in Moderation

So I figured it was time to weigh in with a post about the LIBOR scandal.  I will say upfront that, while it is a scandal, I think that, because of the general bank-bashing atmosphere that prevails in certain media and political circles right now, it has been blown far out of all proportion.  Our own jnc has tended to focus, not unreasonably, on the implications that the scandal presents for the kind of culture that prevails in the finance industry.  While I don’t agree that it is nearly as indicative of a widespread culture of dishonesty and corruption as jnc seems to, I think it is at least a fair question.  I have no time, however, for the Taibbis and Simpsons of the world who are doing their utmost to portray this as some kind of huge and concerted rip-off of Main Street, municipalities, widows and orphans, or whoever else is their latest chosen victim. That is just a bunch of bunk.

There are actually two separate issues here, and they need to be discussed separately. The first is the claim that individual traders were routinely manipulating the daily LIBOR set, both higher and lower, to benefit their trading positions on any given day.  The second is that, during the crisis of ’08, some banks were reporting falsely low borrowing costs in order to keep their funding difficulties from becoming public information.  Let’s address the former first, and perhaps a little history would be useful.  

Prior to the advent of LIBOR swap contracts used many different floating rate indices such as Prime or T-Bills (which is of course manipulated by the Fed as a matter of course), and even at times an individual bank’s own lending rate, determined solely at it’s own discretion.   Then in the mid ’80’s the demon derivatives market invented LIBOR in order to standardize swap contracts by basing them all off of a single, reasonable and standard measure of a “premium” bank’s borrowing cost.   Banks liked this because, even if the published rate was not exactly their own borrowing cost, it was a fair enough approximation to make their contracts sensible. Spreads could be added to this standard for individual contracts to account for the varying credit quality of the contracting parties, but LIBOR would represent a baseline index. In the beginning there were actually competing publishers of daily LIBOR rates, each with their own methodology of calculating the rates.  There were different contributors as well as different averaging and rounding conventions, and so the “standard” wasn’t quite that.  But over time the British Bankers Association’s published BBA Libor became the dominant rate and eventually the market standard.

From the first, LIBOR was defined broadly and was never meant to be some exact rate that mirrored an already established market rate.    In the first place, it’s nature as an average of many different bank rates, with both high and low submissions being deliberately excluded, makes it nothing more than an approximation anyway.  Second, the rate that the BBA requested as submissions was always very subjective.  Originally the BBA simply asked each contributing bank’s opinion of  where an unnamed, generic “prime” bank might be able to borrow:  ““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?”. 

Later, in 1998, it changed it’s question 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?” So now, rather than asking about a hypothetical bank’s borrowing costs, it was asking about the bank’s own borrowing costs.  But note the qualifying and indeterminate language.  What is “reasonable”?  What if you weren’t actually in the market “just prior” to 11 am?  What if you borrowed from three different banks at three slightly different rates? What if you borrowed at 10am, and then saw that the market sold off between then and 11 am? Do you submit your actual rate or what you guess it would have been an hour later? What if you weren’t a borrower at all, but were in fact lending to other banks on a given day?

The main point here is that, contrary to the perception being fostered by outraged pundits and opportunistic politicians, there is no single, objectively knowable “correct” rate to be submitted by any given bank.  Obviously there is not only room for a subjective interpretation and judgment on the part of the  individual submitters, such a judgement is often actually required.  There is some range of rates within which it is perfectly reasonable to have submitted, even of it is not an actual rate that you transacted.  

Now, if one is tasked with submitting the daily rate to the BBA, how does one make this judgement, and is it ethical to be influenced by the entreaties of traders who stand to benefit or lose from your judgement?  That is a fair question and perhaps a point worth debating.  But I actually think it is debatable.  If the nonexistent “correct” rate falls within a range of, say, 3 or 4 basis points, is it really wrong or unethical to take into consideration the financial well being of the company you work for when deciding whether to report the high or low end of the range?  I don’t think so, at least not necessarily.  And the fact that one rate within the band is chosen and not another does not mean that the rate has been criminally “manipulated” or that the rate has been “fraudulently” submitted. As long as the submitted rate is defensible on the merits, regardless of how the judgement was arrived at, I don’t see a problem.  Certainly, in any event, this is not some “criminal conspiracy” akin to the mob shaking people down.  

And in fact the whole process of calculating LIBOR takes all of this into account.  That is precisely one of the reasons that such a wide number of banks (18) are polled and averaged, and why the high and low submissions are excluded from the average. As the BBA itself says, “The decision to trim the bottom and top quartiles in the calculation was taken to exclude outliers from the final calculation. By doing this, it is out of the control of any individual panel contributor to influence the calculation and affect the bbalibor quote.” Which brings us to another, and I think more important question:  Regardless of whether routine attempts to influence the submissions are ethical, were they successful in changing the rate?

That will be the subject of a future post.

Filed under: Big Banks | 15 Comments »