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. I think that we are likely to see a great deal of litigation in the coming months and years as firms and individuals argue that the interest rates they have been paying were fraudulently set. More generally, when market participants lose confidence in something as basic as the interest rate, the market will cease to function.
Q: Were there regulations in place that should have put a stop to this sooner, and if so, why didn’t they work?
A: There are no specific government regulations governing Libor or Libor submissions. The British Bankers’ Association is not an official government agency and merely gathers and publishes the data. And, of course, since Libor is supposed to represent banks’ best estimate, in the absence of incriminating e-mails—as surfaced in the case of Barclays—it is difficult to prove fraud.
Nonetheless, the scandal suggests that the regulators have not been paying much attention. A number of traders interviewed since the scandal broke said that they had long been suspicious of how Libor was set. Writing in the Financial Times recently, former J.P Morgan trader Douglas Keenan wrote that in 1991 he complained to the London International Financial Futures and Options Exchange alleging fraud in the construction of Libor. Colleagues at J.P. Morgan found his complaints naïve to the point of being humorous and the exchange ignored them.
Barclays has so far been fined about $450 million by US and UK authorities, but, of course, those penalties were imposed after the fact.
Q: So how scared should we be?
A: We should be very concerned. The public is already skeptical about the financial system and, with good reason, outraged by the behavior of individual bankers. The financial system plays an important role in promoting economic growth. If that role is impaired, either because the public no longer entrusts the system with its money or because overly stringent regulations strangle it, we will all suffer.
Q: How do you think we can fix the Libor?
A: The problem with Libor as currently constructed is that the incentive for banks to cheat is enormous. The same can be said for virtually any aspect of finance that involves bankers monitoring their own behavior.
In theory, the government could require that banks report each and every transaction to regulators, who could then publish an average cost of funds index. This would be both cumbersome and unlikely to generate the new benchmark in a timely manner. Further, this method would be vulnerable to the same type of cheating that has plagued Libor.
Instead of asking bankers for their best–or worst–estimates, the world’s leading benchmark interest rate ought to be based on a market-determined figure. There are a number of possible alternatives. One that has been mentioned lately is the recently launched GCF Repo index, published by the Depository Trust & Clearing Corporation. The benefit of such an index is that it is determined by a large number of actual trades. Fully 2600 GCF Repo index contracts were transacted on its first trading day. A market-determined figure will better reflect the availability and price of funds than the estimates of a dozen or so people who may have a financial interest in fiddling with the outcome to help their bottom line.