In this issue of The Wesleyan Connection, we ask “5 Questions” of Professor of Economics Richard Grossman. In July, Grossman spoke to the Canadian news magazine Maclean’s about the Libor scandal rocking the global financial industry. Grossman’s 2010 book, Unsettled Account: The Evolution of Banking in the Industrialized World since 1800, reviews banking crises over the past 200 years in North America, Europe and other regions, and considers how they speak to today’s financial crises around the world. He blogs at Unsettledaccount.com.
Q: Professor Grossman, what is the Libor, and what is this scandal all about?
A: “Libor” is the London InterBank Offered Rate. Produced daily for the British Bankers’ Association, it is calculated by asking a group of banks how much they estimate it will cost them to borrow money. Banks are asked to provide estimates of borrowing costs for 15 different maturities ranging from overnight to one year in ten different currencies, so Libor is not one interest rate, but 150. Because not all of the banks deal in all maturity-currency combinations, somewhere between 6 and 18 banks are polled. The highest and lowest estimates are thrown out and the remainder—about half–are averaged to yield Libor. Libor plays a vital role in the world financial system because it serves as a benchmark for some $800 trillion in transactions–everything ranging from complex derivatives to simple home mortgages.
Because so much money is riding on Libor, traders have an incentive to pressure their banks into altering submission estimates to improve their profitability. The scandal is that they did just that. Even a small movement in Libor can lead to millions in extra profits–or losses–for banks.
It has also been alleged that the British authorities encouraged banks to lower their submissions in the wake of the 2008 Lehman Brothers bankruptcy to give the impression that banks had access to plentiful and cheap funds and were therefore less vulnerable to the crisis than they actually were.
Q: Sounds like a big deal for the banks, but why should an average person like me care?
A: If the interest rate you pay on your mortgage, home equity loan, or credit card balance is tied to Libor—and it may well be—then you should be concerned that the rate is set fairly.