Bank lending crisis: Time for a closer look at how Libor is set?
The banks are coming in for intense criticism again. In the Pre-Budget Report, the Chancellor warned he would take “whatever action is necessary” to ensure banks treat business customers “fairly and decently”. This follows briefings to the press that the Chancellor is considering legislation to force banks to lend. And last week, the Chair of the Commons Treasury Select Committee said that full nationalisation may be the only option if the banks do not start lending.
I’ve no doubt that there is a complex equation of factors contributing to the lending crisis which may in the end only be solved by major state intervention. However, there is one possible element in that equation which is currently overlooked: the way Libor (London interbank offered rate – the interest rate at which banks lend to each other) is set.
Everyone agrees that monetary policy is very important and that the setting of the base rate is the main way to exercise that policy. Lots also agree that we need to loosen up monetary policy right now by cutting the base rate to prevent us slipping into an even deeper recession. And everyone seems to agree that cutting the base rate isn’t working because the banks can’t lend at anything close to the base rate and still generate a profit for themselves because Libor is so much higher than the base rate. In short, monetary policy no longer works at precisely the time we need it because Libor is too high.
So we have this very carefully crafted, politically independent architecture involving some of the best economic minds and the best economic data to set the base rate which is rendered ineffective by a separate interest rate that is set by … well, who is Libor set by? To hear some commentators and bankers speak, you’d think Libor was a force of nature that simply found its level. In fact, it is set every working day by the British Bankers Association (BBA) based on a survey of a panel of banks. Full details of the process are published on the BBA site and it raises some interesting questions. Three that occur to me are:
- Is it right that the base rate which is set transparently and in a disinterested fashion is seriously weakened in its effect by a rate that is set in an opaque fashion by a panel that has a vested interest in the impact of their decisions? By opaque I don’t mean that we don’t know what rates the banks propose to the BBA or how the BBA sets the final Libor rates based on those proposals. This data is all published. But there is no way of finding out how or why individual banks propose the rates they do to the BBA each day. Nor is it entirely clear to me what steps are taken to stop banks consulting with each other on the rates they recommend before responding to the BBA.
- Is there something odd about the fact that HBOS and RBS are on the panel that sets Sterling Libor when the BBA’s criteria for membership of the panel includes “reputation” and “credit standing”? These banks have come in for widespread condemnation for their business strategies and have had to be bailed out by the Government due to their parlous financial state.
- Should we be a more concerned about the Libor fixing process right now given that the BBA was forced to make changes to improve the management of the Libor process and conduct a consultation on further changes only a few months ago. This happened after an analysis (subscription necessary) by the Wall Street Journal (WSJ) suggested in May that the banks were fixing Libor at a deliberately low rate. One decision taken by the BBA as part of that inquiry is at least worthy of further investigation. The inquiry consultation document launched for the inquiry (which got a grand total of 31 responses by the way) stated:
It has been suggested that the transparency of LIBOR may be resulting in contributors exhibiting “herd” behaviour, as in the current strained market, which is characterised by funding costs out of line with the market, invites (sic) speculation and rumour mongering in the media. A solution to this might be to anonymise contributions, by ceasing to publish the underlying inputs from contributing banks freeing them to publish a rate without fear of this attracting attention. The majority of the market participants contacted by the BBA and the FX & MM Committee believe this would be a retrograde step. Relevant authorities have also expressed support for transparency and the strength and popularity of BBA LIBOR stem from its fundamental transparency and accountability.
I’m all in favour of transparency but this seems to suggest that the BBA rejected any attempt to address “herd behaviour” for the sake of that transparency. That’s potentially worrying given the urgent need to get Libor down. When the WSJ did its investigation it speculated that individual banks on the Libor panel were fearful of recommending high rates in case it signalled to shareholders that they had more credit problems than their competitors. I must admit to not knowing much about the sorts of calculations banks make when they recommend a rate to the BBA but surely it is not beyond the bounds of possibility given all the political, media and public pressure on banks to pass base rate cuts on to customers that they would be fearful of recommending too low a rate now thus making themselves the target of extra pressure to lend. At the very least, an investigation like the WSJ’s, may be needed to assess whether the rates recommended by the banks are clustering in an improbable manner.
By the way the FX and MM Committee is, I think, the same as the FX and Money Markets Advisory Panel (which the BBA site mentions) and which oversees the Libor setting process. The BBA decided to widen the membership of this panel in the wake of the WSJ claims but I don’t seem to have had much luck finding out who is actually on the panel and how its membership was widened. Maybe I’m looking in the wrong place.
As an aside, Angela Knight, the BBA Chief Executive, skirted over the WSJ claims when she appeared before the Treasury Select Committee back in June although the minutes make reference to some correspondence on the issue.
To be clear, I’m not saying that there is a definite problem here but given that the failure of the banks to lend is driving thousands into unemployment and the economy into recession, I do think these questions need to be asked a bit more widely.