20 April 2017

Libor-ed Into Lowballing

Time for the Bank of England to celebrate its role in saving our financial system?

by Frank O’Nomics

The BBC Panorama programme last week featured recordings of telephone conversations that suggest that in 2008 the Bank of England took steps to encourage traders to set an artificial level of Libor.  The revelations have led to a number of people, not least the Shadow Chancellor, John McDonnell, to call for an inquiry into its role.  However, accusations that the process led to financial loss for schools, the NHS and local councils would seem, on analysis, to be somewhat wide of the mark and, while there are good grounds to criticize the Bank for not clarifying its behaviour before now, there are some justifications for what they may, or may not, have done.  The Bank of England argues: “Libor and other global benchmarks were not regulated in the UK or elsewhere during the period in question”.  However, this is not the same as saying that they were not monitoring the process as part of their role of ensuring the proper conduct of financial markets.

Consider two questions.  How much would you lend to someone that you thought was in danger of going bankrupt?  If you really had to lend them money, what rate would you demand, particularly when similar entities had become insolvent?  The answer to the first question, for most of us, would be nothing – and for the second the rate would be a very high number that reflected the risk of default.  This was the situation in which many banks found themselves in 2008.  The London Inter-Bank Offered Rate, commonly known as Libor, is supposed to reflect the rate at which banks will lend to each other, but if there is no business taking place (and it was clear that Lloyds and RBS were struggling to find anyone that would lend to them other than the government), due to a widespread lack of confidence, the level at which to set Libor is not straightforward.  With the banking system on the brink of collapse an acknowledgement of the extent of this crisis of confidence could have pushed the UK financial system over the edge.

Given this backdrop, for the Bank of England to recommend that banks published what was effectively a hypothetical rate, and for them to encourage those banks to “low-ball” the level, might reasonably suggest two things. First, that the Bank was fully aware of what was going on in the UK financial system, and was effectively fulfilling its duty of close monitoring. Secondly, that it was acting to ease fears and pressures in the system while it made efforts to step in where action was most needed, thereby buying time to introduce reforms to ensure that a new, more robust, environment was created.  By doing this, they could also ensure that the costs of support – which at its peak meant the authorities pledging over £1 trillion, including the bailing out of Northern Rock, Lloyds and RBS – remained at a level which did not put too heavy a burden on the UK taxpayer.

The alternative possibility is that the Bank had no idea of what was going on and genuinely thought that traders were submitting interst levels at which they were prepared to lend each other money.  This stretches credulity, and ignores the daily interaction that the Bank has had with the money markets for centuries.  Following the evidence produced by the Panorama team, which seems to show the Bank actively encouraging UK clearers to “low-ball” their Libor submissions, it might be time for the Bank to come clean about its actions. If it had done so earlier it might reasonably have claimed to have covertly acted to save the fate of our financial system, arguing that desperate times demand desperate measures.

While clarity as to its actions in 2008 would undoubtedly lead to calls to review the convictions of some Libor-riggers, the Bank does not have to condone the activities of traders who, for some years prior to 2008, had been acting where they could to artificially adjust the level of Libor (both up and down) to suit their trading positions. That is very different to submitting low rates to calm a very unsettled and vulnerable market to give a breathing space to some very large domestic institutions. This is where John McDonnell’s assertion that the Bank of England’s action disadvantaged the likes of the NHS and local councils is wrong. Those whose loans were linked to Libor were saved from the worst excesses of the banking crisis by the low-balling process. Those who suffered were those who bought products which ostensibly gave protection against rising rates, but which had an added element to reduce the costs of that protection.  This involved a significant exposure to a fall in rates, which proved very costly and led to the bankruptcy of many. However that was, arguably, the result of their being miss-sold an interest rate swap product, rather than the result of any manipulation of the Libor rate

Those who wish to criticize the Bank of England should decide whether it is because they were blind to events of which most market participants were fully aware, or because they were secretly acting to keep the severity of the situation in check to allow the bank bailout.  On the one hand they are incompetent; on the other they are arguably heroic.  Which is it to be?

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