[By Angus Armstrong, Director, Macroeconomic Research, NIESR]
The damage to the City of London of the revelations of manipulation in the London interbank market cannot be overestimated. The City is the global centre of foreign exchange trading (37% of global turnover), the home of the money markets and half of the $650 trillion global over-the-counter derivatives market. The London Interbank Offer Rate (LIBOR) is the benchmark interest rate on which these transactions are priced, as well corporate loans and even mortgages. According to the IMF’s Article IV Spillover Report the UK's dominance in finance is reinforced by its "robust" market infrastructure, including the setting of LIBOR - the global benchmark interest rate.
While the media is transfixed by whose head will roll, many of the substantive issues around the micro-structure of key funding markets have in fact been known for a long time. Indeed, the real surprise is that the institutions responsible for overseeing financial stability – the Treasury, Bank of England and the Financial Services Authority – and those charged with reforming the banking sector continue to permit patently fragile structures in key funding markets. This tolerance probably reflects the persistent ideology that financial markets are somehow efficient and so the structure is best devised and operated by those who use them. If there is a silver lining from these revelations it is that plans to reform the financial sector are still on the drawing board: there is still time to reconsider.
The interbank market emerged in the 1970s as a market for balancing short term credits and debits in different currencies. Banks were thought to have an advantage in screening and monitoring each other and hence the market was more efficient than official channels. However, this also created problems. When credit concerns became an issue, the markets became fractured due to credit rationing and illiquidity. Banks' willingness to borrow at higher interest rates was taken as confirming suspicions of credit weakness, e.g., Stiglitz and Weiss, 1981.
But LIBOR is not an actual borrowing rate. It is a (trimmed) average of interest rates that banks report that they could borrow funds in a reasonable size just prior to 11am each day. So in periods of distress there is an incentive for banks which borrow at typical rates (so not trimmed) to submit lower interest rates to avoid this perverse signalling effect. Collusion could be an even more powerful way of forcing interest rates lower. Moreover, modern banks also hold very large positions in over-the-counter derivatives which are priced relative to LIBOR. This creates a second direct incentive to influence the reference rate.
Of course, these problems are not new. In the wake of the Herstatt banking crisis in 1974, which led to credit rationing and illiquidity, a communiqué from the G10 central bank Governors in 1974 (a precursor of the Basel Committee) included the following statement with reference to the interbank market: 'while it is not practical to lay down in advance detailed rules and procedures for the provision of temporary support to banks facing liquidity difficulties, the means are available for that purpose, and will be used if and when necessary' (quoted from a book by my NIESR colleague E. Philip Davis, 1995).
So it has been known for some time that these market structures create unintended incentives which could threaten the integrity of the market; and more recently, there has been evidence that this is exactly what is happening. In 2008 an article in the Wall Street Journal article suggested that several global banks had reported unjustifiably low borrowing costs. Academic papers have been also provided evidence of how LIBOR rates are inconsistent with other borrowing costs with the suggestion that banks had acted 'strategically', for example Snider and Youle, 2009.
So what should the policy response be? Two weeks ago the Government published its White Paper on Banking Reform: Delivering Stability and Supporting a Sustainable Recovery. This is essentially a watered-down version of the Independent Commission Banking's (ICB) recommendations. However, neither report contains any discussion of the structure of the markets which banks use to fund themselves. It is as if banking stability can be achieved irrespective of how well the markets in which banks fund themselves function. Indeed, the fact that in modern banks asset allocation decisions are taken simultaneously with funding decisions seems to have escaped all notice. It is impossible to have a stable banking sector if the funding markets on which they depend are fragile, let alone subject to manipulation.
Consider the micro-structure of another key funding market for UK banks, the mortgage backed securities market. Efficient securitisation can certainly support financial stability. However, the current unregulated UK securitisation market is both unbelievably complex and prone to even more fragility. Quotes posted on screens are not even historic prices and volumes are unknown, so an outside investor cannot carry out even the most basic risk management. UK banks have raised around Euro 200bn since the market re-opened in 2009, but these are the same securities which transmitted crushing illiquidity to the sponsoring banks back in 2007. The lack of discussion about the structure of these key funding markets in any of the UK banking reform proposals is a very serious omission.
So while the LIBOR scandal is extremely damaging to the reputation of the City of London, there is a potential silver-lining; a much more comprehensive review of the problems facing UK finance. In our reviews of the ICB’s proposals (see our press releases here and here) we concluded that ‘there will only be a real reduction in excessive risk taking when (a) the incentives of those working in the industry change, and (b) the social cost of poorly functioning wholesale and shadow banking markets are addressed’. Since this assessment, what has happened? The bonuses awarded to the heads of universal banks have increased, even as it has become apparent that the most important wholesale capital market has been manipulated. Neither concern is even mentioned in the Government’s White Paper or the ICB’s interim and final reports. Financial stability will require a much more comprehensive set of reform proposals than currently exist.