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the limits to libor April 17, 2008

Posted by Bradley in : Uncategorized , trackback

The story that banks may not have been reporting rates accurately for the construction of libor is, as Paul Krugman notes, worrying. Worrying because it suggests that the funding situation for major banks (in the interbank market) is worse than we know. Worrying because some of this problem is caused by a lack of confidence in banks and the financial system generally. Worrying because if it turns out to be true that some of the major banks which are members of the BBA’s contributor panels have been quoting inaccurate rates then confidence will, justifiably, suffer even more than it already has.

The underquoting risk was suggested, for example in an article by Jacob Gyntelberg and Philip Wooldridge in the BIS Quarterly Bulletin:

The widespread use of fixings as reference rates also gives contributing banks an incentive to misquote. The costs of manipulating a given rate might be outweighed by the potential profit from positions based on those rates … For example, market participants with large positions in derivative contracts referencing a rate fixing might seek to move the fixing higher or lower by contributing biased quotes. Alternatively, they might indirectly influence the accuracy of the fixing by choosing not to join the contributor panel.
The scope for such strategic behaviour to influence the fixing can to some extent be limited by trimming, in which biased or extreme quotes are disregarded. However, even trimmed means can be manipulated if contributor banks collude or if a sufficient number change their behaviour.

The description of such underquoting as merely “strategic behaviour” is troubling to me, when the higher rates might suggest a market perception of counterparty risk that might be material to investors in an underquoting bank’s securities. Surely it is more serious, more troubling, than just strategic behaviour? But the idea that it may be acceptable for a borrower to manipulate the appearance of its creditworthiness has surfaced before. Another author, writing in the BIS Quarterly Review in 2006 stated that a utilisation fee for a loan:

enables the borrower to announce a lower spread to the market than what is actually being paid, as the utilisation fee does not always need to be publicised.

Is there a way to rescue BBA libor? The BBA does have the ability to exclude banks from its contributor panels, although deciding whether or not to do so must be a complex problem, particularly given the profiles of the banks in question.The BBA’s US dollar panel is: Bank of America, Bank of Tokyo — Mitsubishi UFJ, Barclays Bank plc, Citibank NA, Credit Suisse, Deutsche Bank AG, HBOS, HSBC, JP Morgan Chase, Lloyds TSB Bank plc, Rabobank, Royal Bank of Canada, The Norinchukin Bank, The Royal Bank of Scotland Group, UBS AG, and West LB AG.

Over the last few months, 3 month libor has often been significantly higher than the effective federal funds rate. So, from the perspective of mortgage borrowers with libor-based mortgage loans, as the WSJ points out, lower rates produced by any underquotes are a good thing.

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