The arrogance of the British Bankers Association (the “BBA”) and the lack of interest on the part of the United States Government in connection with the issues surrounding LIBOR continue to amaze me.
LIBOR (the “London Interbank Offer Rate”) is supposed to be “the actual rate at which banks borrow money from each other”. And, LIBOR denominated in US dollars is supposed to be the actual rate that US banks borrow money from one another.
According to the Wall Street Journal (June 11, 2008, U.K. Bankers to Alter Libor to Address Rate Doubts) there is approximately $350 trillion of dollar denominated debt and contracts that are based upon LIBOR. Consumers, businesses, municipalities and the capital markets depend upon LIBOR to establish the fair cost of borrowing and lending. Banks are suppose to use LIBOR as a benchmark interest rate that approximates their marginal cost of borrowing, i.e., a sort of average measure of a banks’ cost of funds, so that fair and transparent interest rates for borrowers can be established. When a bank quotes an interest rate of LIBOR plus 1.00%, it is intended to mean that the bank that is providing the loan is earning a gross return over its cost of funds of 1.00%. However, if LIBOR isn’t accurate then the underlying premise of fair and transparent pricing of United States credit markets is brought into question and the integrity of the domestic banking system is undermined.
Unfortunately, as I have discussed in earlier blog entries, LIBOR is not a real market rate of interest and is instead set by a cartel of mostly foreign banks operating in London with little or no oversight and no transparency. As such, United States businesses and consumers that have borrowed in LIBOR indexed terms have not paid a fair rate of interest above their bank’s cost of funds.
In response to criticism relating to how LIBOR is established, on June 10, 2008 the BBA announced that it would be “reforming” the LIBOR setting process. This announcement was a “reversal” of previous positions taken by the BBA.
Unfortunately, what the BBA decided to do is not real reform but instead a reaffirmation of what is a fatally flawed system.
After the new set of “reforms” is enacted LIBOR will continue to have the following attributes:
- LIBOR will not be a market rate of interest. There continues to be no “bid/offer” market quotation system for determining LIBOR rates. No one will know if LIBOR actually reflects real transactions, composite estimates of real transactions, fictional transactions that might have occurred but for some reason didn’t or transactions that are just “made up out of thin air”.
- US dollar LIBOR will not be the rate that US banks borrow and lend to one another in the United States. LIBOR will continue to be determined by mostly foreign banks in London. If there is a correlation between LIBOR and the cost of funds of United States banks operating in the United States it will be coincidental.
- LIBOR will continue to be “set” by a cartel of banks that can collude without any consequences. The BBA has neglected to establish any real reporting or enforcement mechanism to dissuade banks from not reporting false LIBOR rates. The BBA’s enforcement concession is broaden the membership of the BBA review committee and to “scrutinize” (after false rates are reported) the rates that were used to establish LIBOR. However, there is no mention of “real time” enforcement of market established rates of interest. And, it is a good bet that the expanded review committee will not include any non-BBA members who have a real interest in ensuring the fairness and accuracy of LIBOR (such as consumer and business representatives, independent research and/or accounting firms or government officials).
There are no standards for review or accuracy. The BBA has avoided the question of how much of a misreporting of actual costs of borrowing is bad enough for it to take action. No “standards for review” means that there will be “no standards for enforcement”.
Numbers can help to put some prospective on this issue. Assuming that LIBOR is off by 0.01% (i.e., 1 basis point), United States consumers and businesses will either pay too much or too little interest by approximately $100 million per day (or approximately $35 billion per year). However, when the question of LIBOR accuracy was raised it appeared that LIBOR was off by more than 0.25%. That means that interest rates were being mischarged by approximately $2.5 billion per day or almost $1 trillion per year.
The Wall Street Journal reported that the BBA is hesitant to change how LIBOR is calculated because it is worried about legal liability which is not a surprise. If the BBA admits that LIBOR isn’t a market rate but a cartel rate that was established through price fixing, it will be subject to global lawsuits resulting from fraudulent behavior and misrepresentations. The likelihood of the BBA reforming itself, providing transparency and giving up its cartel monopoly is very low given the astronomical liability that will result.
LIBOR and the BBA remind me of a saying that I have often heard from Eastern European business people.
“Everything the Communists told us about communism was a complete and utter lie.”
“Unfortunately, everything they told us about Capitalism turned out to be true.”