With central bankers and market participants rushing to find an alternative to the London Interbank Offered Rate (or Libor), the interest-rate index that sets borrowing costs for consumers and multinational corporations, it’s a good time to ask where Libor came from. And to ask how the midmorning estimates of a handful of London-based bankers came to play such an outsized role in the modern, quant-driven financial system.
Libor represents the cost of one large bank borrowing unsecured funds from another, in various currencies and at varying maturities, in the London market. Each day, the British Bankers’ Association asks a panel of market participants, “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 a.m.?” The answers are then compiled and published by Thomson Reuters Corp. (Bloomberg LP, the parent of Bloomberg News, competes with Thomson Reuters in selling financial and legal information and trading systems.)
In recent months it has become clear that many bankers misreported rates, either to benefit trading positions or provide a false picture of stability to regulators, undercutting the market function Libor was meant to perform.
This system was developed by the BBA in 1985, but the interbank rate in London, which has been referred to as Libor since the early 1970s, first became a significant global benchmark in the early ’60s. London was then becoming the center of a growing market for dollar deposits and dollar loans -- known as Eurodollars -- which were held by individuals and institutions outside the U.S. and were thus free from oversight by American regulators.
In the early ’60s, the fragility of the Bretton Woods system of fixed exchange rates pushed U.S. policy makers to restrict international bank lending originating within the U.S. The Federal Reserve, along with the Kennedy and Johnson administrations, feared that dollar outflows linked to international lending would endanger U.S. dollar reserves and thus the global financial system.
This fear, most now agree, was unfounded, and ironically domestic regulation simply pushed American bankers and multinational corporations to relocate these functions offshore. London banks had been lending Eurodollar since the early 1950s, and the city’s tradition as a haven for transnational finance made it a logical site for a market in unregulated dollars. Large corporations seeking to finance international operations, as well as nations looking for dollars to help make up balance-of-payments deficits, turned to the London Eurodollar market through the ’60s and ’70s.
The structure of this market brought Libor to the fore. Eurodollar deposits at London banks were usually made on a short-term, fixed interest-rate basis. To match their loan and deposit maturities, banks lending Eurodollar structured their loans to roll over, usually every six months. If, in the meantime, a lending bank’s dollar deposits moved to another institution, the lending bank would seek to reacquire dollars by borrowing them from other banks in the London interbank market.
This system created significant interest-rate risk for lending banks. So to protect themselves from rate fluctuations, they would charge Eurodollar borrowers a percentage above the interbank rate commensurate with the borrower’s credit standing. In 1970, for instance, the electronics company Philips arranged a $250 million loan at 0.75 percent over Libor, while in 1975 the Soviet Union borrowed $300 million at 1.25 percent over. To handle loans of such size, banks formed syndicates to spread the risk; the Philips deal involved a group of more than 50 banks.
At the time, however, there was no uniform index for determining the true interbank rate, or reference rate, for these loans -- the function Libor is now meant to serve.
Banks involved in syndicated loans could expect to borrow in the market at slightly different rates. For each loan, then, reference banks that were deemed representative of a cross section of the syndicate -- or, for more neutrality, banks outside the syndicate -- were chosen by the parties. The rates at which these reference banks could borrow would be aggregated to form the “interbank rate” for the purpose of the loan.
This method was cumbersome, and offered multiple opportunities for manipulation. This was especially true in London, where an older banking culture of gentlemanly capitalism prevailed, and where favors and family connections were still central to a bank’s success.
First, large banks could increase their yields by bringing smaller, slightly less creditworthy firms into a loan syndicate, raising the reference rate for the group as a whole, while the large bank’s borrowing costs remained low.
More worrisome were gentlemen’s agreements intended to squeeze a few extra basis points from the quoted Libor. This method was described by the Financial Times in 1974: “whereby Bank A agrees to quote a slightly above realistic Libor for the purposes of fixing the rate payable by a customer of Bank B -- on the understanding that Bank B will do the same for Bank A when the time comes.”
In the context of London’s banking culture, such arrangements were accepted practice -- keep calm and carry on.
Whether rigged or not, the use of the interbank rate shifted interest-rate risks to borrowers, and in the turbulent climate of the late 1970s financial institutions developed new tools to offset these risks. The most important of these was the interest-rate swap, a form of derivatives contract that allowed a party to hedge differences in short- and long-term interest rates.
Unlike Eurodollar loans, which were unique agreements between set parties and usually not salable in a secondary market, swaps were intended to be liquid, so that firms could adjust their risk portfolio as the interest-rate market changed. Here, the multiplicity of possible Libors made the development of a transparent market difficult, because each swap contract might have different terms and be linked to different reference banks. Nonuniformity was a significant problem in a market already estimated to be worth several trillion dollars in the mid-1980s.
The rise of the derivatives market generally, and interest-rate swaps in particular, thus created the need for a more systematic index. In 1985, the BBA published its Recommended Terms for Interest Rate Swaps, which was meant to bring uniformity to the derivatives markets as well as systematize the Libor-setting process. Although most of these terms were rejected in favor of standards created by the International Swap Dealers Association, the legacy of this effort was the rationalized Libor system still in place today.
But rationalization did not -- as the global market is increasingly discovering -- free Libor from the clubby London banking networks that had made the interbank rate subject to manipulation in the first place. As the Libor scandal continues to unfold, we shouldn’t be surprised if we hear more of history’s echoes.
(Sean Vanatta is a graduate student at Princeton University. The opinions expressed are his own.) Read more Echoes columns online.
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