Libor explained: the real cost of money or just a fix?

So, just after I posted the last entry, titled If We Are On A Precipice, the Banks Will Be the First To Go, Again, it occurred to me to just double check that I am not the first person to think of this, as I am hardly the smartest person in the room.  And of course, just this April there was an explosion of articles around an investigation into Libor collusion by a number of big banks.

The article below, by Jamie Dunkley and Harry Wilson from The Telegraph, goes on to explain how Libor is set each day.  One topic it seems to ignore is an analysis of the number of banks setting Libor before 2008 and the number of banks setting Libor today.  If you are willing to consider my unsubstantiated conspiracy theory, my best guess is there are far fewer players, with much better means to collaborate in setting Libor.  After all if a few college kids can help overthrow a government in the Middle East using Facebook, its not that extreme to think a few bankers could BBM each other to hide the panic they all feel.  Afterall its now a serious game of poker, but if one man folds, they all must fold together, game over.  If I am right, which I hope I am not, we will not get a waring shot from the TED spread this time, and the only way we will know that the banks are about to become insolvent is when they all fail simultaneously.  Could this be why the 2-year treasury is paying 20 basis points, and the 5-year is paying about 1%? For the answer, see: Occam’s Razor.

By , and Harry Wilson
6:06AM GMT 17 Mar 2011

Libor explained: the real cost of money or just a fix?

It is the monetary policy committee you have probably never heard of – a group of bank treasurers and officials from the British Banking Association that set interest rates for trillions of pounds worth of international lending each working day.

It is the monetary policy committee you have probably never heard of - a group of bank treasurers and officials from the British Banking Association that set interest rates for trillions of pounds worth of international lending each working day.

The Libor setting process used to involve a daily telephone call between participating banks and the BBA. But, this has become more advanced as technology has improved.

At 7am every morning a cycle begins that ends four and a half hours later with the calculation of the London Interbank Offered Rate, or Libor as it is more commonly known. Libor is the average rate at which a bank can obtain unsecured lending and is produced in ten currencies with 15 different maturities quoted for each, ranging from overnight to 12 months.

Across the City, treasurers at more than 15 major banks sit glued to their screens monitoring the money markets and working out how much working capital their institution needs to meet the billions of pounds of liabilities on their balance sheets.

As the banks’ financial positions are assessed, so-called “ladder reports” are compiled, setting out how much each needs to borrow. At each contributing bank they must answer one simple question: “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?”

The Libor setting process used to involve a daily telephone call between participating banks and the BBA. But, this has become more advanced as technology has improved.

These days, responsibility for each bank’s submission is still in the hands of the treasurer, or head of asset and liability management, although the transfer of data now involves the use of a secure computer system managed by data and information company Thomson Reuters.

Banks submit their figures through the protected system, which immediately discards the four highest and four lowest figures – using an average of the remaining numbers to calculate Libor.

Once calculated, the number is broadcast on the Thomson Reuters system and through other information systems such as Bloomberg, with each individual banks’ submission published simultaneously enabling market participants to challenge figures if they do not think they reflect the actual rate being offered.

BBA Libor was established in 1984 as demand grew for an accurate measure of the rate at which banks would lend money to each other. This became more important as London’s status as an international financial centre grew and is now the basis for everything from how much a small UK business can borrow at to US residential mortgages costs.

But critics argue Libor has become a meaningless measure of borrowing costs since the onset of financial crisis as the interbank lending rates remain artificially low due to the hundreds of billions of pounds of central bank support that have kept them open.

“You effectively have people making up the numbers, because there aren’t thousands of trades for them to look at to get a handle on what the number should be,” said one London-based banker.

At the same time, Libor’s importance has been undermined by other measures of lending costs, namely Eonia and Sonia, which track overnight swap rates and are based entirely on the actively traded market for interest rate swaps.

Supporters point out that Eonia and Sonia barely flickered when Lehman Brothers filed for bankruptcy in mid-September, having priced in for several months the funding problems of the banking sector. By contrast, Libor spiked before plummeting as central banks flooded the financial system with money.

News that UBS and other banks are under investigation for alleged manipulation of Libor has been met with surprise by some traders.

“This is the ultimate credit market. The sheer size of the market is beyond the manipulation of any one bank and to be effective would require the collusion of every participant, in which case you’d be looking at something rather more serious than just trying fix Libor,” he said.

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