Libor was introduced in 1986 as a measure of wholesale interbank lending rates. The thinking was that the economy and politics had become too complex for ordinary citizens to understand. And that the best way to handle it was to allow the experts to take over.
They were perceived to be skillful and knowledgeable enough to manage economically and politically important institutions (including banks).
The events of 2008 2009 shattered that belief. The next casualty is Libor–the London Interbank Offer Rate.
Libor in a nutshell
The British Bankers’ Association introduced Libor in 1986 as a measure of wholesale interbank lending rates.
Libor is essentially set by “expert judgment.” Each day, a panel of banks submits its estimated cost of lending to another bank for various time periods to the ICE Benchmark Administration.
What this means in practice is that only some of the bank submissions are based on real underlying transactions, and the rest are left up to traders’ estimates. In 2015, for example, about 70 per cent of the submissions were experts’ guesses.
Scandals that destroyed Libor’s credibility
Two developments since the crisis of 20082009 motivated the Financial Conduct Authority to end Libor.
The first was a scandal in 2014 in which traders at several large banks were found to be conspiring to manipulate Libor rates to benefit their own trading positions… and so their bonuses.
The second is the decline in wholesale interbank lending in the post-crisis years. Andrew Bailey, the chief executive of the FCA, has perhaps focused on the second cause in his explanation of why Libor must be abandoned.
According to the FCA, with fewer real transactions on which to base the benchmark rate, Libor becomes more and more dependent on expert guidance -that is, submissions by bank managers -which isn’t sustainable in the long run.
With increased regulation following the 2014 scandal, there is a risk that banks that currently submit Libor rates will choose to leave the panel, making the benchmark rate more dependent on the estimates of fewer financial entities.
What will replace Libor?
There’s some uncertainty about what will replace Libor, since several potential alternative rates have been proposed.
In the United States, a panel of 15 banks voted in July to support a rate based on overnight secured lending against US Treasuries. The idea is that this new rate would be based on real transactions between banks and other private entities, not the guesswork of traders trying to bump their annual bonuses.
But Libor is a rate for unsecured lending, which means that the new rate would likely be lower than Libor. For loans that are based on Libor or comparable indexes, this presents a problem for the banks: If they decide to switch to this new secured rate for existing contracts, their loans will become less profitable. This is just one possible replacement, but the inverse could also become true–costs could go up for borrowers of all types, from homeowners to students to businesses.
The demise of Libor is part of a bigger trend
The financial concerns about Libor are legitimate. But this sort of reform wouldn’t have occurred without scandals.And these scandals would not have come to light if it were not for the investigation into bank lending and trading practices that began after the 20082009 financial crisis.
The crisis killed the idea that “experts” can manage the complex systems with which they have been entrusted. This is about more than the financial system. There is growing mis trust of experts.
The demise of Libor is just one example of the consequences stemming from this lack of faith.
A split has formed between people who generally trust the counsel of technocrats and those who question their intent… or at least their competency. That split is becoming increasingly visible in the West.
In Europe, this has taken the form of distrust of EU policies and national politicians who advocate for them. In the US, it has pitted those with enduring confidence in elites against those suspicious of them.
Divisions will only get worse as governing institutions fall victim to their own complexities and fail to provide the services their constituents want them to.There will be more financial (and other) reforms that try to respond to this growing unease.
But as with most reforms, there will be winners and losers.