Libor’s value is called into question - By Gillian Tett

By Gillian Tett
September 25 2007
Source

In recent weeks, the British Bankers Association – a trade body in London – has embarked on a novel briefing mission.

While the BBA used to receive few requests for information about how it compiles the London Interbank Offered Rate – or Libor – it has recently been bombarded with queries about this benchmark.

Consequently, this summer the trade body started disseminating these rates to a wider audience for the first time, together with notes explaining how the benchmark works.

In some respects, this thirst for information is unsurprising. As the credit squeeze has spread in recent months, the Libor benchmark has, at least until recently, risen relentlessly.

Consequently, many observers have seized on these rates as a handy, visible litmus test of banking stress, not least because the rest of the interbank market tends to be very opaque and thus not easily monitored.

While these pressures have propelled Libor into public view, it has come at the very moment that some bankers are quietly starting to question its value.

In particular, the recent turmoil is prompting suggestions that Libor is no longer offering such an accurate benchmark of borrowing costs as before.

As a result, some bankers are beginning to suggest that the status of these indices may need to be reconsidered in the future.

“The Libor rates are a bit of a fiction. The number on the screen doesn’t always match what we see now,” complains the treasurer of one of the largest City banks.

Such criticism is, unsurprisingly, rebuffed by those who compile the index each day. However, it highlights two other trends that have emerged in the money markets in recent weeks.

One of these is a growing divergence in the rates that different banks have been quoting to borrow and lend money between themselves.

For although the banks used to move in a pack, quoting rates that were almost identical, this pattern broke down a couple of months ago – and by the middle of this month the gap between these quotes had sometimes risen to almost 10 basis points for three month sterling funds.

Moreover, this pattern is not confined to the dollar market alone: in the yen, euro and sterling markets a similar dispersion has emerged. However, the second, more pernicious trend is that as banks have hoarded liquidity this summer, some have been refusing to conduct trades at all at the official, “posted” rates, even when these rates have been displayed on Reuters.

“The screen will say one thing but people are actually quoting a different level, if they are quoting at all,” says one senior banker.

Some observers think this is just a short-term reaction to the current crisis. However, it may also reflect a longer-term shift. This is because one key, albeit largely unnoticed, feature of the banking world in recent years is that many large banks have reduced their reliance on the interbank market by tapping cash-rich companies and pensions funds for finance instead.

The recent crisis appears to have accelerated this trend. In particular, it appears that some large banks have in effect been abandoning the interbank sector in recent weeks, turning to corporate or pension clients for funding by using innovative repurchase agreements.

This trend is bad news for smaller institutions, such as British mortgage lenders, because these, unlike large banks, generally do not have any alternative ways of raising funds outside the interbank world.

Thus it is that these institutions appear to have suffered worse from the latest squeeze.

Few observers expect this pattern to reverse soon. Or as David Clark, a former senior banker, notes: “The use of three- and six-month Libor or Euribor as a benchmark reference interest rate will have to be reconsidered as nowadays, even in good times, banks rarely lend each other unsecured funds for such periods.”

And this has another important, short-term implication: namely that even if Libor rates do fall in the coming weeks, this may not mean all the pressures on banks have entirely come to an end. Or, at least, not for some small institutions which are currently scrambling to raise funds – and finding it hard, irrespective of what the computer screens might suggest.

Background

The BBA Libor benchmark first emerged in the 1980s, because of industry demand for an accurate measure of the rate at which banks would lend money to each other.

As London’s status as an international financial centre subsequently grew, the role of BBA Libor also rose, and it is now used to calculate the interest rates for a range of financial instruments and derivatives around the world.

Donald Mackenzie, a finance professor at the University of Edinburgh, estimates that financial derivatives totalling $150,000bn are indexed to BBA Libor.

The BBA calculates the rates together with Reuters each day, usually before noon UK time.

It assembles the interbank borrowing rates from 16 contributor panel banks at 11am, looks at the middle 50 per cent of these rates and uses these to calculate an average. These are then posted on Reuters as the BBA Libor rate.

This process is followed 150 times to create rates for all 15 maturities (ranging from overnight to 12 months) and all 10 currencies for which a BBA Libor rate is quoted.

In addition to sterling Libor rates, there are also rates for dollars, euros and others.

Copyright The Financial Times Limited 2007