The LIBOR/ TIBOR ‘Scandal’
The large fine imposed on RBS last week suggests that a ‘scandal’ took place in the banking world over the setting of LIBOR. Yes – there was probably systematic mis-pricing of LIBOR which enabled some traders and some banks to profit at the expense of others. But the LIBOR issue simply highlights a much wider problem in financial markets which is that many ‘prices’ quoted in markets are not market prices at all. Instead they are prices based on computer models, matrix pricing or sheer guesswork, which may or may not produce ‘accurate’ prices. The reason for using computers models and guesswork is that in many financial products there actually are no transactions at all or very few even over periods of some weeks or months and thus no market prices.
In fact the key function of a market is to ‘discover the price’ so the problem with any asset which does not trade frequently is that prices have to be ‘made up’. LIBOR, for example, is calculated by the British Bankers Association (BBA) based on the answers received to this question which is posed daily to major banks:
“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”
Unfortunately, as the BBA website notes:
“libor is not necessarily based on actual transactions, as not all banks will require funds in marketable size each day in each of the currencies/ maturities they quote and so it would not be feasible to create a full suite of LIBOR rates if this was a requirement. However, a bank will know what its credit and liquidity risk profile is from rates at which it has dealt and can construct a curve to predict accurately the correct rate for currencies or maturities in which it has not been active.”
In other words, LIBOR rates are ‘made-up’ numbers.
The reason why this problem became worse after the financial crisis broke out in 2007 is that from the date on, banks generally were very unwilling to lend to each other at all, particularly as such lending is unsecured, unlike mortgage lending for example. Instead, banks were mostly lending to the Bank of England which acted as an intermediary and in turn, lent on to other commercial banks and thereby took on the risk of their collapse and consequent losses which other commercial banks would not. Thus numbers simply had to be made up. What bank, in such circumstances, would want to signal to the world that it would have a problem trying to get a loan from another bank by quoting a higher number rather than a lower one? All the incentives were towards quoting a lower rate.
In the case of the comparable set of rates based on the Japanese yen rather than on sterling or dollars, there has been an even greater problem. There are two reference rates for yen, one is LIBOR in yen which is used internationally and one is TIBOR which is the domestic reference rate. They should be the same and, before 2009 they were. However, the Financial Times quotes a former ‘star’ trader in Tokyo as saying that the way in which banks there made excessive profits without the knowledge of customers was by using the lower LIBOR rate when arranging to borrow funds and a higher TIBOR reference rate to lend funds. Indeed, the industry association for the banks in Japan has stated that in December 2012, actual transactions in yen between banks were going through at 0.17% while TIBOR was at 0.32%. Since mortgages are based on a base rate of TIBOR plus a spread (margin), banks were making not only the spread quoted to customers but also benefitting from actually borrowing money at around half the rate of the official base rate.
The problem of poor pricing of assets which don’t actually trade is widespread. Indeed, the first intimations of the financial crisis occurred with the closure of Dillon Read’s hedge funds (a unit of UBS bank), as early as May 2007. The closure resulted from losses on collateralised debt obligations (CDOs) which were subsequently to prove the initiating factor of the financial crisis. When homeowners in the United States started defaulting in much larger numbers on their mortgages in March 2007:
“John Niblo, a hedge-fund manager at Dillon Read, acted fast. He twice slashed his fund's valuation of securities tied to ‘subprime’ mortgages, knocking them down by about 20%, or nearly $100 million. But managers at UBS AG, Dillon Read's parent company, were irate. The Swiss banking giant was carrying similar securities on its books at a far higher price, the traders say. In conference calls, the UBS managers grilled Mr. Niblo on his move. "I'm marking to where I could reasonably sell them," Mr. Niblo responded during one call, according to the traders familiar with the conversations. UBS later shut down the in-house hedge fund, and Mr. Niblo was let go (fired) in August. Last week, UBS announced a $3.7 billion write-down on $23 billion of securities with mortgage exposure, including securities from the shuttered fund. Such pricing problems have become common in some of Wall Street's biggest markets. Today, ‘way less than half’ of all securities trade on exchanges with readily available price information. As a result, money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles -- a process known as marking to market. An official at the Securities and Exchange Commission said recently that some bond mutual funds might be using outdated or unrealistic prices to value their portfolios.”
The moral for you and me is – don’t buy complex securities or invest with managers who do, since such securities may not be saleable subsequently and thus may have little value if you want your money back. Instead invest only in securities which trade frequently and have daily trading prices and only trust managers who stay in assets with quoted prices. This is also the conclusion reached by the head of state of the Group of 20 (G20) major countries. In 2009, they came to an agreement which required banks around the world to shift the trading of many swaps contracts from what is called OTC trading (where prices lack transparency) to exchange traded contracts and central clearing and reporting in order to try to reduce the problem of securities and contracts which traded ‘behind closed doors’. Hopefully, this will soon be achieved some four years later and if it is should help in trying to minimise the factors which will lead to future financial crises.
Professor Brian Scott-Quinn Chairman, ICMA Centre & Director of Banking & Investment Banking Programmes ICMA Centre for Financial Markets, Henley Business School, email@example.com firstname.lastname@example.org
Professor Scott-Quinn's recent book on the international markets, "Commercial and Investment Banking and the International Credit and Capital Markets - a guide to the global finance industry and its governance" published in August 2012 by Palgrave, can be 'seen inside' on Amazon.
|12 February 2013