August 7, 2012
AMERICANS who save for the future, use credit cards or borrow money for tuition, cars and homes deserve assurance that the interest rates on their savings and loans are set in a reliable and honest way.
That’s why the revelation that the British bank Barclays attempted to manipulate the London interbank offered rate, or Libor — one of the benchmark rates used to determine the cost of borrowing around the world — is so disturbing. But the Barclays case isn’t only about misconduct by large financial institutions. It also raises questions about the reliability and accuracy of these key interest rates, which are largely determined by the private sector, without significant government oversight.
When you save money in a money market fund or short-term bond fund, or take out a mortgage or a small-business loan, the rate you receive or pay is often based, directly or indirectly, on Libor. It’s the reference rate for nearly half of adjustable-rate mortgages in the United States; for about 70 percent of the American futures market; and for a majority of the American swaps market, where businesses hedge risks from changes in interest rates.
Libor is supposed to be the average rate at which the largest banks honestly believe they can borrow from one another unsecured (that is, without posting collateral). Libor was set up in the 1980s when banks regularly made loans to other banks on that basis.
However, the number of banks willing to lend to one another on such terms has been sharply reduced because of economic turmoil, including the 2008 global financial crisis, the European debt crisis that began in 2010, and the downgrading of large banks’ credit ratings this year.
Banks have shifted toward secured borrowing and, on occasion, borrowing from central banks like the Federal Reserve and the European Central Bank. As Mervyn King, the governor of the Bank of England, said of Libor in 2008: “It is, in many ways, the rate at which banks do not lend to each other.”
These changes in the markets raise questions about the integrity of this important benchmark.
First, why is Libor so different from another benchmark interest rate for borrowing in United States dollars — Euribor, or euro interbank offered rate? Both rates are calculated on the basis of banks’ answers to roughly the same question. For Libor, a bank is asked at what rate it thinks it can borrow, while for Euribor, a bank is asked at what rate it thinks other banks are able to borrow. And yet the Euribor for dollar borrowings is about twice as high as the comparable Libor.
Second, why have Libor and other benchmark rates typically not been aligned, since 2008, with the borrowing rates that would be implied by foreign exchange markets? A long-established financial theory known as interest rate parity says that the difference in interest rates between two countries should be roughly in line with the expected change in exchange rates between the countries’ currencies. (If it isn’t, that opens an opportunity for arbitrage, the practice of taking advantage of price differences.)
Until 2007, as the theory predicted, the difference between the borrowing rate in one currency and the lending rate in another could typically be derived from foreign currency exchange rates. In the last few years, that hasn’t been the case, and this divergence between theory and practice has yet to be adequately explained.
Third, why is the volatility of the dollar-denominated Libor so much lower than the volatility of other short-term credit market rates? Just like stocks and bonds, short-term interest rates experience a certain volatility. But Libor has less severe swings than comparable rates.
In addition, the variation in rates that some banks submit to the British Bankers’ Association — the private group that oversees Libor — don’t seem to match the variation in the rates for their credit default swaps (financial instruments that are similar to insurance and are one measure of a bank’s credit risk). There have been times when the swap rates have widened for particular banks (suggesting a growing credit risk) even as their Libor submissions have remained stable (suggesting that the banks’ borrowing costs haven’t changed).
Anyone saving or borrowing for the future has a real stake in the integrity of Libor and in the answers to these questions.
When the Commodity Futures Trading Commission, which oversees derivatives markets, began looking into interest-rate setting in 2008, we were guided not only by questions about the decline of actual unsecured lending among banks, the supposed basis of Libor, but also by our founding statute, the Commodity Exchange Act. The law prohibits attempts to manipulate and falsely report information that tends to affect the price of a commodity — including interest rates like Libor.
Markets work best when benchmark rates are based on observable transactions. The public is shortchanged if Libor, the emperor of rates, is not clothed in such transactions.
One solution might be to use other benchmark rates — like the overnight index swaps rate, which is tied to the rate at which banks lend to one another overnight — that are based on real transactions. There are also benchmark rates based on actual short-term secured financings (loans in which collateral is pledged) between banks and other financial institutions.
For any new or revised benchmark to be broadly accepted by the financial markets, borrowers, lenders and hedgers who rely on Libor would benefit from a process for an orderly transition.
The Barclays case demonstrates that Libor has become more vulnerable to misconduct. It’s time for a new or revised benchmark — an emperor clothed in actual, observable market transactions — to restore the confidence of Americans that the rates at which they borrow and lend money are set honestly and transparently.
Gary Gensler is the chairman of the Commodity Futures Trading Commission.
Last Updated: August 8, 2012