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The LIBOR ‘scandal’ has been all over the news for two weeks now. The real scandal is not what the accused banks have done, but unquestioned legitimacy and ability of central banks to fix the rate of interest, one of the most important prices in any economy.
Firstly, Barclays could not possibly have manipulated LIBOR on its own, because of the very nature of the way LIBOR is calculated. LIBOR (London Interbank Offered Rate) is calculated by the British Bankers Association each day. A bank’s cash desk sends in its LIBOR rate to Thomson Reuters at 11am, and once all contributions have been received, the highest 25% and lowest 25% of the rates submitted are excluded (the trimming process), and the remaining contributions are then arithmetically averaged to create the BBA LIBOR rate.
If Barclays’ submission was too high or too low, their LIBOR submission would not form part of the calculation. There must have been a majority of banks colluding to ‘fix’ the rate.
If 16 banks are submitting LIBOR rates, the participation rate during the period when Barclays is accused of ‘fixing’ LIBOR, at least eight banks must therefore agree or collude on a certain LIBOR rate before sending in their submission, in order to manipulate the rate. Of course, this is theoretically possible.
Which leads me to the second point. The cash desks of these banks are all either long/short cash in their active trading positions, so it is a stretch for them all to agree to ‘set’ LIBOR at a predetermined level. A higher rate would benefit some, but at the expense of others. The probability of agreement being found here is nearer to nought than one hundred.
Thirdly, even if agreement could be found, because LIBOR is an interest rate off which many market rates pivot and are calculated (sort of like the prime rate in SA), if LIBOR was set too high for underlying market conditions, it would result in a demand and supply mismatch for loans.
If LIBOR was set too low, it would result in market interest rates that the banks charge their customers being too low, and result in an excess demand for loans, and a shortage of loans. If LIBOR was set too high, it would result in a decline of demand for loans, but a rise in supply of loans, thus resulting in a mismatch of supply and demand for loans.
If LIBOR was being set at levels that don’t correspond with monetary realities, credit market chaos would result, and banks would stop using LIBOR as a benchmark for its loans.
Fourthly, and here is the crux of my argument: LIBOR tracks the US Treasury Bill rate, and vice versa, but both track the Federal funds rate. The Federal funds rate is the interest rate that the central bank of the United States government fixes, by manipulating the amount of money available in the interbank money market. To do this, it prints money.
The 3-month Treasury Bill yield, is the interest rate at which the United States government borrows. Clearly, the 3m T-Bill rate tracks the Federal funds rate, which is set by the Federal Reserve.
The 3-month LIBOR rate, like the 3-month T-Bill yield, tracks the Federal funds rate. The spike in LIBOR in late 2008 was a result of the Lehman bankruptcy, not LIBOR ‘manipulation’.
So in other words Barclays and other banks stand accused of colluding to fix interest rates by a basis point or two, but central banks manipulate interest rates by 400-500 basis points at a time. The first chart above is of the interest rate that the central bank, the Federal Reserve in this case, manipulates on a daily basis, by draining or adding cash reserves to the monetary system.
By manipulating this key interest rate off which all others pivot, central banks can single handedly create massive distortions of relative prices in the economy, generate the boom-bust business cycle, create asset bubbles, create low government borrowing costs that encourages the government to go into more debt than it can afford to repay (think Greece, Spain, Ireland, etc), create price inflation that harms the poor the most, to mention a few things.
The focus of the LIBOR ‘scandal’ should be on the central banks of the world, not the commercial banks (although the latter are implicit in the rigged game, as my colleague Russell Lamberti so eloquently points out in the Mail and Guardian this week. The banks can do nothing close to the damage that the central bank can and does do. The real scandal is the central bank’s unquestioned legitimacy and ability to be the price fixer of one of the most important prices in the economy, as opposed to millions of savers and borrowers voluntarily transacting to find the real free market interest rate, like they are supposed to.