Judged by the
amount of money directly dependent on it, the British Bankers’ Association’s
London Interbank Offered Rate matters more than any other set of numbers in the
world. Libor anchors contracts amounting to some $300 trillion, the equivalent
of $45,000 for every human being on the planet. It’s a critical part of the
infrastructure of financial markets but, like plumbing, doesn’t usually get
noticed. Only a handful of economists, and no other academics, have ever looked
in any detail at Libor, and even the financial press didn’t show much interest
in how Libor is calculated until this spring, when there was sharp controversy
over whether these crucial numbers could be trusted.
The calculation
of Libor is co-ordinated by just two people, who work in an unremarkable
open-plan office in London’s Docklands. I watched the process, which seemed
utterly routine, a couple of years ago. Just after 11 a.m. on every weekday
that’s not a bank holiday, traders at leading banks send in their estimates of
the interest rates at which their banks could borrow money. They do this
electronically, but sometimes the co-ordinators make a phone call to a bank
that hasn’t sent in its estimates, and if the latter seem implausible – typos,
for example, are fairly common – they’re checked, also with a quick call: ‘Hi
there, is the Kiwi chap [provider of the estimates for borrowing New Zealand
dollars] about? … Bit of a spread on the two month. Everyone else is coming in
a good bit under that.’
A simple
computer program discards the lowest quarter and highest quarter of the
estimates, and calculates the average of the remainder. The result is that
day’s Libor. The calculation is repeated for each of ten currencies and 15 loan
durations (from overnight to 12 months), so 150 Libors are published daily:
overnight sterling Libor, one-week euro Libor, one-month yen Libor, three-month
US dollar Libor and so on.
It’s the
back-up arrangements that tell you something about how much the calculation
matters. The co-ordinators have dedicated phone lines laid into their homes so
they can still work if a terrorist attack or other incident stops them reaching
the office. A similarly equipped building, near the office, is kept in constant
readiness, and there’s a permanently staffed back-up site in a small town
around 150 miles from London (I won’t be any more precise than that). Its
employees periodically work in the London office, so that they’re ready to take
over if need be.
The precautions
are necessary because if Libor suddenly became unavailable, large parts of the
global financial system would be paralysed. The 150 numbers constitute the
dominant global benchmark for interest rates. The rates on borrowing, amounting
to around $10 trillion (corporate loans, adjustable-rate mortgages, private
student loans and so on), are pegged to Libor. For instance, the level of Libor
determines the monthly payments on around half of the adjustable-rate mortgages
in the US: rates are set as Libor plus a fixed margin, and are reset
periodically as Libor changes. Even in the UK, where explicit pegging of this
kind is rarer, Libor is a big influence on mortgage rates.
Libor is an
even more important factor in the huge market for interest-rate swaps. These
are contracts in which one bank or other organisation pays a fixed rate of
interest on a given amount of money to another bank, which pays a floating
(that is, variable) rate – such as three-month US dollar Libor – on the same
amount. The total amounts involved, added up across the globe, exceed $300
trillion. Measured that way, the swaps market is the biggest financial market
of them all, and most of it depends on Libor.
Invented only
at the start of the 1980s, swaps enable lenders and borrowers to eliminate the
risk of interest-rate changes. Take fixed-rate mortgages, for example. Without
swaps, a bank might be reluctant to offer them, because it generally pays its
depositors floating rates, and also borrows from other banks at floating rates.
If interest rates go up, the bank will therefore have to pay out more, while
its revenue from its fixed-rate mortgages stays the same. (As rates rose
sharply in the 1980s, almost all the savings and loan associations in the US –
the equivalent of the UK’s building societies – were caught out in this way.
The resulting crisis, a precursor of today’s credit crunch, pushed more than
700 savings and loans into insolvency, and the rescue operation ended up
costing US taxpayers around $130 billion.) Entering into a swap in which the
bank pays a fixed rate and receives a floating rate enables it to cancel out
the effect of changing interest rates, and conditions in the swaps market are
thus a major influence on the terms on which fixed-rate mortgages are available.
The very possibility of a large-scale swaps market depends on the availability
of a measure of interest rates that is unequivocal and credible enough to form
the basis for contracts denominated in billions of dollars. Libor has provided
that measure.
In a financial
world dominated since 1945 by the US, it’s striking that the global benchmark
is a set of London rates. Paradoxically, the reason for this is Britain’s
failure – crystallised in the 1957 sterling crisis – to re-establish the pound
as a major international currency after the war. That prompted the leading
British banks increasingly to lend, borrow and accept deposits in US dollars
(‘eurodollars’, as they came to be called). The Bank of England overcame its
initial anxieties and came tacitly to support the eurodollar market, and the
Johnson administration inadvertently encouraged it by trying to stem the flow
of dollars overseas. Eurodollar operations conducted in London allowed US banks
to circumvent the new controls.
The result was
that London became – and in many ways remains – the centre of the international
money markets. ‘Money’ here does not mean cash, but short-term loans between
banks and other major institutions; more than a fifth of international lending
of this kind still takes place in London. Crucial to facilitating this market –
and to enabling Libor to be calculated – were, and are, London’s money brokers.
They emerged in the 1960s as a challenge to the traditionally staid,
gentlemanly, top-hatted sterling money markets, in which lending took place via
designated ‘discount houses’ backed by the Bank of England. Money brokers put
lenders and borrowers directly in touch with each other, charging a fee for
doing so. The business is fast-moving, and competition fierce and sometimes not
at all gentlemanly. If you listen to brokers’ voices, you hear the tones of the
East End and Essex more often than those of Eton or Harrow. Open-necked shirts
are more common than suits and ties. While banks’ dealing rooms are now often
disappointingly quiet and orderly places – in reality there’s far less shouting
and swearing than in film portrayals – brokers’ offices are more tightly packed
(there’s less space between desks) and more raucous.
Suppose a bank
wants to borrow or lend in the interbank market. (It might want to lend because
no bank likes to leave cash idle, even for the shortest period. Indeed,
overnight lending is the busiest sector of the interbank market, with banks
that have excess cash at the end of the working day lending to those that need
it.) A bank’s money-market traders could directly contact their counterparts in
other banks, but it’s usually quicker and easier to work through the brokers.
This can now be done on-screen, but – especially if large sums are involved or
market conditions are tricky and changing rapidly – it’s often better to use
the ‘voicebox’. This is a combination of microphone, speaker and switches that
instantly connects each broker by a dedicated phone line to each of his clients
in banks’ dealing rooms.
If a bank wants
to borrow money, a broker needs quickly to find someone who is prepared to lend
at an attractive rate; if a bank wants to lend, he – it’s a predominantly male
profession – needs to find a borrower ready to pay a good rate. So at any given
time a broker needs to know who wants to borrow, who is prepared to lend, and
on what terms. As one of them said to me, a broker might ‘speak to his big
clients … maybe 25 times a day, which is 25 times as often as they speak to
their wives’.
A broker needs
to pass information to his clients as well as to receive it: that’s a major
part of what they want from him, and a good reason to use the voicebox rather
than the screen. The brokers’ code of conduct prohibits passing on private
knowledge of what a named bank is trying to do (unless a client is about to
borrow from it or lend to it), but that restriction leaves plenty of room for
brokers to tell traders what has just happened and to convey the ‘feel’ of the
market. There’s a grey area in which euphemisms can be used: in context, a
trader might know exactly which bank is meant when the broker tells him that
‘the usual German’ has just done something.
Brokers in
major money-market currencies don’t work as individuals, but in teams of up to
a dozen or more, sitting close together in subsections of large, open-plan
offices. Good eyesight is useful – trainees still sometimes called ‘board boys’
write unfilled bids to borrow and offers to lend on whiteboards surrounding
clusters of brokers’ desks, and you can occasionally see a broker using
binoculars to read a distant whiteboard or screen – but a more crucial skill is
‘broker’s ear’: the capacity to monitor what is being said by all the other
brokers at nearby desks, despite the noise and while at the same time holding a
voicebox conversation with a client. As one broker put it to me: ‘When you’re
on the desk you’re expected to hear everyone else’s conversations as well,
because they’re all relevant to you, and if you’re on the phone speaking to
someone about what’s going on in the market there could be a hot piece of
information coming in with one of your colleagues that you would want to tell
your clients, so you’ve got to be able to hear it coming in as you’re speaking
to the person.’
When you first
encounter it, broker’s ear is disconcerting. You’ll be sitting beside a broker
at his desk, thinking he’s fully engaged in his conversation with you, when
suddenly he’ll respond to a question or comment, from several desks away, that
you simply hadn’t registered. It’s an embodied skill that affects the way Libor
is calculated. The inputs to the calculation are provided daily by the
money-market traders from banks that are on panels established by the British
Bankers’ Association. There is one panel for each currency, and those for the
main currencies each have 16 banks on them. What each bank has to provide is
the rate at which it could borrow funds (‘unsecured’ – that is, backed only by
the bank’s creditworthiness, not more specific collateral – and ‘governed by
the laws of England and Wales’), ‘were it to do so by asking for and then
accepting interbank offers in reasonable market size just prior to 11.00’ in
the currency and for the time period in question.
Note the
conditional: a Libor input is what a bank could do, not what it has done. So
judgment is involved. A bank might not have borrowed anything in the minutes
before 11 a.m. Deals for longer than overnight are intermittent, and there is
little borrowing at some of the time periods involved, such as 11 months.
‘Reasonable market size’ is deliberately not defined exactly: it will vary from
currency to currency and according to time period and market conditions. The
need for judgment is why the information provided by brokers is important to
the calculation of Libor. It helps a bank’s traders to estimate the rate at
which they could borrow money, even if they’re not trying to do so. They get
some of the information they need from the screens provided by their various
brokers: all serious traders employ several. The screens indicate the lowest
rate at which banks are currently offering to lend and the highest rate at
which they are prepared to borrow. Only the naive, however, would give the
former rate as their Libor input. The screens don’t reveal the amount actually
available for borrowing at the lowest quoted rate, and it may fall short of
‘reasonable market size’. It could range from a mere $50 million or so to a
yard or more (‘yard’ – originally an abbreviation of ‘milliard’ – is the
money-market term for billion, a word that in a noisy environment is all too
easy to confuse with ‘million’).
The screens
can’t be expected to tell you with any precision how much you would have to pay
to borrow a few hundred million dollars (reasonable market size for short-term
borrowing in a major currency), and are even less reliable when it comes to
borrowing several yards. It can take an experienced trader talking to a number
of brokers with good ears to form a realistic estimate. There’s also an element
of judgment in the rates that brokers put on the screens: they can, for
example, consider it as misleading their clients to quote a bid to borrow at an
unusually high rate, if it comes from a bank with poor credit standing to which
many of their clients would be reluctant to lend.
Originally, Libor
was an informal notion, and when different sets of banks were polled the
resultant Libors could differ by as much as 25 basis points (a basis point is a
hundredth of a percentage point). The current British Bankers’ Association
system for calculating Libor, involving a fixed procedure and predetermined
panels of banks that change only infrequently, was set up in 1985, and has
worked remarkably well, which is why the participants in financial markets are
prepared to have $300 trillion indexed to Libor.
The obvious
risk to the integrity of the calculation is that a bank on a Libor panel might
make a manipulative input, trying to move Libor up or down so as to influence
interest rates or the value of its swaps portfolio. That risk is the main
reason for the exclusion from the calculation of the highest quarter and lowest
quarter of inputs. Furthermore, once a day’s Libor rates are set, each input –
and the name of the bank that has made it – is also disseminated
electronically, and so attempts at manipulation would have to take place in
what is in effect the public gaze. The inputs to Libor can be viewed around 45
minutes after they are made on more than 300,000 computer terminals worldwide,
and they are thoroughly scrutinised. On one occasion, well before the recent
problems, a banker showed me the day’s inputs into three-month sterling Libor,
pointing with suspicion to a bank that had reduced its input – by a single
basis point – from the previous day’s, while all the others had either
increased theirs or left them unchanged. The brokers see and hear a lot. An
input wildly at odds with what their screens show would be obvious, and word of
persistent attempts at manipulation would quickly spread as brokers chat with
their clients. The ultimate sanction – used in the past, I was told, but not
recently – is a bank’s removal from a Libor panel. In the current climate, that
would deeply damage the bank’s reputation.
The strength of these long-standing
fortifications around Libor’s status has been questioned over the course of the
last twelve months. Ever since the rescue of Northern Rock, whether or not
banks are sound, whether they are prepared to lend to each other, and sometimes
even the levels of Libor have been topics for TV news, not just the Financial Times. Much of
the most vocal criticism of Libor has come from the US, and has focused on
dollar Libor – especially three-month dollar Libor, the rate used more than any
other in the swaps market. Some seem unhappy that the benchmark dollar interest
rates are set in London just after 6 a.m. New York time, when traders are only
starting to arrive at their desks, and that the US dollar Libor panel contains
only three recognisably ‘American’ banks. The British Bankers’ Association –
membership of which is open to any bank operating in the UK, wherever it is
domiciled – counters by pointing out that all the banks on the panel are global
institutions, some with a major presence on the ground in the US, and that
collectively they are responsible for most London interbank dollar lending and
borrowing.
The most prominent critic has been the Wall Street Journal. It
has suggested that the public dissemination of banks’ inputs – which is
intended to make the process more transparent – has the effect of biasing
inputs downwards, because banks fear that reporting publicly that they can
borrow only at high rates would spark rumours about their creditworthiness. On
16 April, under the headline ‘Finance markets on edge as trust in Libor wanes,’
the WSJ reported
a claim by Scott Peng, an analyst at Citigroup, that although, because of the
credit crunch, Libor was already high relative to the rates set by central
banks, it should be even higher. Three-month US dollar Libor, Peng suggested,
should actually be 30 basis points higher than it was – a difference that
represents huge amounts of money, given the trillions of dollars indexed to it.
The British Bankers’ Association responded
by telling the WSJ
that it was monitoring inputs closely and that if it was ‘deemed necessary’, it
would ‘take action to preserve the reputation and standing in the market of our
rates’ – a warning that the WSJ
read as a threat to remove any bank making dubious inputs. Over the next two
days, three-month dollar Libor rose by 16 basis points, but in a context in
which rates have been highly volatile it’s impossible to be certain that this
was because of the WSJ’s
reporting, the British Bankers’ Association’s statement, or different factors
altogether. Central bankers began watching the controversy over Libor closely,
the FT reported,
‘because some officials fear that the debate could be contributing to a broader
sense of investor unease in the money markets’.
Given the criticism of Libor, why not
abandon its conditional aspect (the submission of rates at which banks could borrow), and shift,
as some critics have suggested, to an index based on actual transactions? At
least two such indices already exist. Eonia (Euro Overnight Index Average),
calculated by the European Central Bank, is a weighted average of the rates of
overnight interbank loans denominated in euros. Sonia, its sterling equivalent,
is a similar average of overnight loans transacted via London’s main money
brokers.
Eonia and Sonia
have their attractions. In June, LIFFE, the London International Financial
Futures Exchange, whose interest-rate contracts have traditionally been based
on Libor, launched additional contracts based on Eonia, and it would like to do
so using Sonia, although it hasn’t yet got permission from the index’s owners
(the leading brokers). But the names of the two indices indicate their
limitations. They are averages of overnight lending, and the market for
longer-duration interbank loans is probably too patchy to sustain credible
indices based directly on the transactions that have actually taken place.
Right now, much more than a week can seem far too long a time for a bank to
lend its carefully husbanded cash to one of its peers. It’s also the case,
brokers and traders told me, that until the Bank of England applied sustained
pressure – and eventually, in May 2006, instigated reforms – the sterling
overnight market could be unruly, with surprisingly volatile rates strongly
influenced by position-taking on the part of individual big banks.
It’s also an
illusion to think that indices based on transactions can’t ever be manipulated.
‘Closing prices’ – the average of the day’s final deals on an exchange – are
widely used as indices, but there’s then sometimes an incentive to ‘bang the
close’, in other words to trade aggressively in the final minutes or seconds so
as to influence the closing price. In July, the US Commodity Futures Trading
Commission charged three oil traders with allegedly doing just that.
A potential
alternative to Libor as a benchmark, at least as far as the US dollar is
concerned, is the New York Funding Rate, launched by the brokers Wrightson ICAP
in June. Its poll of banks is conducted in the US at 9.15 a.m. New York time;
inputs are anonymous; and each bank is asked to report the rates at which a
typical bank with a high credit rating could borrow, not those at which it
itself could. Despite these differences, however, the resulting numbers have
tended not to differ much from US dollar Libor. What could have been a rival
has in practice provided a confirmatory second opinion that has helped restore
confidence in Libor. The membership of the panels of banks that make Libor
inputs may now be broadened, and a new British Bankers’ Association
subcommittee will draw on independent third-party analysis of inputs and have the
power to demand that banks justify any that seem anomalous. So the controversy
seems to be passing. Nevertheless, its sharpness, and how unsettling some
market participants seem to have found it, indicate just how important Libor is
to the world’s financial system.
On 23 October, Donald
MacKenzie writes: My article on Libor went to press just before Lehman Brothers
filed for bankruptcy and governments in the US and Europe had to intervene to
avert the collapse of much of the global banking system. As the article
explains, Libor anchors contracts totalling about $300 trillion, the equivalent
of $45,000 for every human being on the planet. It is calculated from banks’
reports of the rates of interest at which other banks are prepared to lend them
money. This interbank lending has come close to drying up at each of the peaks
of the credit crunch, and the failure of Lehman Brothers and the subsequent
banking crisis caused it to do so almost entirely. Libor has therefore been
attempting to capture conditions in what has become nearly a non-existent
market.
Promises of
massive infusions of government capital, and government guarantees that those
who lend to banks will get their money back, seem now to have stabilised the
international banking system somewhat, although no one imagines the crisis is
over. One of the government’s priorities is to get banks lending to each other
again, and if they succeed that will help repair the foundations of Libor.
There are indeed signs that lending to banks is resuming, and Libor rates have
gradually been edging downwards. On 13 October, for example, three-month US
dollar Libor was 4.75 per cent; a week later it was down to 4.06 per cent.
The widespread
state intervention in the banking system will, however, pose new questions, such
as how to treat, when calculating Libor, those interbank loans that are
guaranteed by governments. The interest rate on such loans will be lower
(perhaps much lower) than loans without that guarantee, and that could affect
the value of Libor considerably. For many years Libor was part of the unnoticed
infrastructure of financial markets. Now, I expect, it will remain in the
spotlight for some time to come.