The Sunshine Report

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.”