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Lies, Damn Lies, and LIBOR


As the LIBOR probe continues, key questions need to be brought up about the rates, the banks, the data, and what it all means for markets and regulation.

This past week we saw the LIBOR investigation get ratcheted up. There have been allegations of manipulation followed by investigations, lawsuits, and requests for immunity. It has been going on for about a year, but to really understand what this probe is all about, you need to go back further in time. Specifically, you need to go back to the time of the credit crunch. If you want to solve a crime or figure out what happened at an accident, you have to go back to the scene.

But before we do that, what is LIBOR? Officially, it stands for the London Inter-Bank Offer Rate, and it is published daily by the British Bankers Association, or BBA for short. Sounds rather fancy, doesn't it? You'd think there were all sorts of black-box algorithms run on computers with fancy switches and quite possibly a hyperdrive button being used.

But really, LIBOR is a rather simple concept. The following explanation comes from the BBA's website:
Every contributor bank is asked to base their bbalibor submissions on the following question; "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?" Therefore, submissions are based upon the lowest perceived rate that a bank on a certain currency panel could go into the inter-bank money market and obtain sizable funding, for a given maturity.

The rates are not necessarily based on actual transaction, indeed it would not be possible to create the suite of bbalibor rates if this was a requirement, as not all banks will require funds in marketable size each day in each of the currencies and maturities they quote. However, this does not mean the rates do not reflect the true cost of interbank funding. A bank will know what its credit and liquidity risk profile is from rates at which it has dealt, and can construct a curve to predict accurately the correct rate for currencies or maturities in which it has not been active.

So instead of talking about algorithms and nanosecond calculations, I'm sure the submitters are more likely to talk about whether or not Wayne Rooney's hair plugs have increased his goal scoring capabilities or how grateful they are that Piers Morgan is here in the US now. One question, five maturities: overnight, one month, three months, six months, and one year.

While the BBA asserts that a bank will know its credit and liquidity risk profile from rates it has dealt, let's insert a little game theory in here. A bank may know its credit and liquidity risk profile based on such information, but would the bank share it? The discussion here quickly morphs into prisoner's dilemmas and stag hunts and all manner of game theory. Here, you're bound to be better off by underreporting the rates you trade at. Because as the explanation states, interbank trades don't always occur each day. So what's the incentive to divulge information about your funding and liquidity that could possibly increase "rainy day" funding costs? There isn't one.

But now, let's go back to the credit crunch, specifically the time period between 2007 and 2009. Don van Deventer of Kamakura Corporation was kind enough to furnish me with some data from that time period and, truth be told, he has been ahead of this issue and has done a lot of work in analyzing what happened. As Fox Mulder was fond of saying, "The truth is out there."

From that data, I created a chart that shows the average LIBOR/Eurodollar basis of the LIBOR panel banks' three-month LIBOR submissions in blue, as well as the daily standard deviations of that basis in red. The Eurodollar data comes from the Federal Reserve, but not much else is known about their nature. But since Eurodollar deposits are offshore dollar-denominated bank deposits, I'm assuming we're talking about more than just 16 or 17 banks and we're seeing actual deposit rates. For this chart, I used 15 of the 17 banks in the population. Societe Generale (SCGLY.PK) entered the panel when HBOS exited, so I didn't use them:

At the height of the crisis, with literally everything hanging in the balance, LIBOR rates were nearly 200 basis points lower than Eurodollar rates. While the standard deviation increased a good bit, all of the banks submitting LIBOR rates for three-month money still had a negative basis to Eurodollars. It was just a question of how negative.

Again, think of the way the panel is surveyed and what they are answering. What is the incentive? Especially when you notice the way three-month Eurodollar rates behaved during the same time period? The only other explanation I can think of is a "too big to fail" spread. But in that environment, who would've wanted to take chances on that?

If you read Don's blog, you'll see that Eurodollar rates – not LIBOR – have a strong relationship with default risk. That's a big deal because essentially, LIBOR is supposed to measure counterparty credit risk. Yet, it doesn't look like it's a meaningful indicator for doing that.

These findings should have folks asking a lot of questions. What do we want to know? Do these rates tell us what we want to know? If not, how should we find that out? Is there a way these numbers can be reviewed independently and simply? Clearly, there's a lot of soul-searching that needs to be done.

Twitter: @japhychron
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