Monday , 26 June 2017

LI(e)BOR: All You Need to Know – and Why You Should Care

The very nature of the ques­tion used to solicit rates from the contributing banks to establish the LIBOR (London Interbank Offered Rate), tells you all you need to know. The banks are asked, in effect, “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 bank is sup­posed to sub­mit a rate where they think they could bor­row, not where they actu­ally bor­rowed, or where they would lend to other con­trib­u­tors…and, as such, LIBOR has always had an ele­ment of “games­man­ship” if not out­right lying. [Here’s what you should know about what LIBOR is, how it is established and why you should really care.]  Words: 1100

So says Peter Tchir (www.Mar­ in paraphrased excerpts from his original article*.

Lorimer Wilson, editor of (Your Key to Making Money!), has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.

Tchir goes on to say, in part:

How is LIBOR cal­cu­lated?

The BBA pro­vides pretty detailed analy­sis of the process. The key here is what the rate is meant to be. The con­trib­u­tors, are sup­posed to sub­mit a rate for each cur­rency they con­tribute for overnight, one week, two week, and monthly out to a year….The bank is sup­posed to sub­mit a rate where they think they could bor­row, not where they actu­ally bor­rowed or where they would lend to other con­trib­u­tors.

[Why should you and I care about any of this? Because LIBOR is used as the foundation for a host of other interest rates. Everyone is affected by LIBOR: it influences the payments made on mortgages and personal loans, and those received on investments and pensions.]

Right from the start the ques­tion raises ques­tions that have been dis­cussed for years:

  • How can a bank “know” where some other bank will lend them money?
  • Can’t they use trans­ac­tions?
  • Can’t they get firm “offers” from other banks?
  • Why not have the banks sub­mit lev­els where they would lend to other banks?

The very nature of the ques­tion used to solicit rates tells you all you need to know. LIBOR has always had an ele­ment of “games­man­ship” if not out­right lying.

In gen­eral, banks will tend to sub­mit lower rates and attempt to arti­fi­cially lower LIBOR. There are two rea­sons for this:

1. The Sig­nal­ing Effect: Banks don’t want to say it would cost them more money to bor­row than their peers because that would be admit­ting to weak­ness and may cause their lenders to pull back and cre­ate a financ­ing freeze. Each contributor’s LIBOR indi­ca­tions are pub­lished so if a bank shows up with a par­tic­u­larly high esti­mate of what it would cost to bor­row, it would attract unwanted atten­tion. It may be the truth and should be evi­dent in the CDS and bond mar­kets, but for some rea­son banks remain con­cerned about the sig­nal­ing impact and tended to skew LIBOR sub­mis­sions lower than they should have been.

2. Risk and P&L Impact: The big banks always have a lot of risk asso­ci­ated with LIBOR. It will affect:

  • their bor­row­ing costs,
  • what they receive on float­ing rate loans and
  • the value of their inter­est rate deriv­a­tive books.

It might have other sec­ondary impacts, but those 3 areas are big.

It is prob­a­bly safe to say that banks in gen­eral ben­e­fit from lower LIBOR, but that won’t be true for all banks and won’t be true for all days. There are occa­sions where banks may ben­e­fit from a higher LIBOR. If they have a dis­pro­por­tion­ately large amount of float­ing rate loans reset­ting on that day, they may ben­e­fit by hav­ing LIBOR higher that day, thus lock­ing in slightly higher income for that period. Some­one at the bank will know their expo­sure to the LIBOR set­ting on any day, and it would be hard to believe that on days when the expo­sure is large either direc­tion, the group that sub­mits it would be unaware of the poten­tial P&L impact.

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The above reasons are a dan­ger­ous con­coc­tion. The ques­tion they are asked (“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?”) leaves a lot of wig­gle room, and banks that may have strong incen­tives to use that “wig­gle” room.

Con­trols and Actual Cal­cu­la­tions

For me, the sin­gle most impor­tant rate is the 3 month USDLIBOR rate. It cer­tainly impacts Amer­i­cans more than any other rate cal­cu­lated by the BBA. Here is yesterday’s sub­mis­sions, and the calculation.

There are 18 banks that sub­mit U.S. LIBOR. The 4 low­est rates and 4 high­est rates are thrown out for pur­poses of the set­ting. Then LIBOR is set as the aver­age of the remain­ing 10 rates.

You can see the wide dis­crep­ancy in rates. HSBC and Barclay’s clearly think they have easy access to money. Soc­Gen and BNP seem to think it would cost them a lot of money rel­a­tive to the oth­ers. There is no indi­ca­tion how much bor­row­ing and lend­ing is occur­ring in the inter­bank mar­ket, so there is no easy way for an out­sider to tell if this reflects real­ity or not. JP seems con­ser­v­a­tive given that their 5 year CDS trades at 125 which is sim­i­lar to HSBC’s 120 level. Barclay’s 5 year trad­ing at 205 would indi­cate a pos­si­bly opti­mistic view of where they could get short term fund­ing, and Citi and BAC barely behind JPM again seems a bit opti­mistic given their CDS trade at 235 and 250 respectively.

By throw­ing out the out­liers, and using a rel­a­tively large pool to cal­cu­late the aver­age, the BBA attempts to mit­i­gate the risk of any one bank skew­ing the set­ting. The prob­lem is that it doesn’t do much if mul­ti­ple banks col­lude to manip­u­late the setting. If mul­ti­ple banks have the same incen­tive to skew their own sub­mis­sion, and worse yet, com­mu­ni­cate that to “friendly” banks, then the BBA method­ol­ogy breaks down further. The prob­lems with the BBA method­ol­ogy is there is no con­fir­ma­tion that the rate sub­mit­ted is rea­son­able, and noth­ing is done to pro­tect against group rather than indi­vid­ual bias in their sub­mis­sions….

Ulti­mately the LIBOR set­ting process will have to change. The cur­rent process is too vague. There have been some calls for an alter­na­tive to LIBOR, but with so many con­tracts out­stand­ing, I think that is unlikely. It will be far eas­ier to just amend the method­ol­ogy and try to improve the exist­ing LIBOR process rather than start­ing an entirely new rate series….

*  (To access the above article please copy the URL and paste it into your browser.)

Editor’s Note: The above article may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

 Related Articles:

1. A Libor Primer

2. Libor Manipulation

3. LIBOR: The Crime of the Century

4. LIBOR Was a Criminal Conspiracy From the Start