Libor Punishment Could Be Worse Than the Crime

People are rightly appalled at the way bankers manipulated Libor, a benchmark interest rate that influences the value of hundreds of trillions of dollars in financial contracts worldwide.

But before authorities topple more banks’ managements and scrap an indicator that has served the market for three decades, they should ask themselves a question: Who was really harmed?

The most significant misreporting of the London interbank offered rate, in an economic sense, occurred during the financial crisis. Banks lowered the borrowing rates they reported for the calculation of Libor because they wanted to avoid the impression that they were in distress. Some estimates suggest U.S. dollar Libor might, at certain times during 2008, have been artificially depressed by more than 0.30 percentage point.

The misreporting was bad for investors in various securities, such as mortgage bonds tied to Libor, because it artificially lowered the payments they received. It also provided a welcome relief for millions of struggling U.S. homeowners with floating-rate mortgages, and greatly helped the Federal Reserve in its efforts to get interest rates down. At the time, the Wall Street Journal estimated that the benefit to homeowners and other borrowers amounted to more than $10 billion a month -- a meaningful stimulus at a crucial moment in the recession.

Utility Functions

This vast transfer of wealth was not necessarily a zero-sum game, because the winners and losers were very different people. In economic terms, they had different utility functions: A $100 break on a monthly payment would mean a lot more to an unemployed homeowner than a loss of $10,000 to a relatively wealthy investor. So it’s probable that, on balance, the benefit to homeowners outweighed the suffering of investors.

In other words, by lying about their borrowing costs to make themselves look healthier than they were, banks might actually have done humanity a great service. The people and institutions harmed were largely sophisticated types who should have known what they were getting into. Although anyone who committed fraud should be punished to the full extent of the law, authorities should consider this context in deciding what to do with the senior managements of the banks involved.

There is, of course, no guarantee that at some point in the future, bankers won’t have an incentive to overstate their cost of funds as systematically as they understated it during the crisis. It’s hard, though, to imagine a situation that would compel them to do so. Individual banks have different investments that a rise in interest rates would affect in complex and conflicting ways. Only something as powerful as the fear of bank runs can override those varied interests. In such cases the incentive is always the same: Push rates down to avoid looking weak.

Libor actually works pretty well most of the time. Outside of crisis periods, dollar Libor closely tracks interest rates on U.S. Treasuries. Any significant divergence would immediately set off alarm bells and create arbitrage opportunities, limiting banks’ ability to manipulate the rate. When crises do happen, the incentives to lie arise in a way that -- thanks to the Libor scandal -- we now understand pretty well.

Any potential replacement for Libor could entail all kinds of new and less manageable flaws. Consider the general collateral repo rate, the rate at which banks make loans against good collateral, such as Treasuries. It has the advantage of being based on actual, observable loans, as opposed to Libor, which relies on banks to estimate their borrowing costs. Yet the repo rate is also tied to supply and demand in the Treasury market, which can fluctuate in unpredictable ways -- for example, when global investors are looking for a safe place to park their cash.

Keeping Libor

In some markets, then, it might be best to stick with Libor. One solution would be to separate Main Street from Wall Street, in much the same way we do by allowing only wealthy, sophisticated investors to put their money in hedge funds. Consumer products such as mortgages and auto loans could be pegged to the central bank’s target interest rate, as is already done in some countries. Financial professionals could decide on the best benchmark for all their derivative contracts and so on. If they still prefer Libor, so be it.

For all its shortcomings, Libor is the evil we know. Before we throw it out and start over, we should consider the potential for unintended consequences.

(Mikhail Chernov is a finance professor at the London School of Economics. He has worked as an academic consultant to various institutions, including the U.S. Federal Reserve, the Bank of England and Barclays Plc. The opinions expressed are his own.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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