When the financial sector has a need, it invents lucrative new products to fill it. These products are often magnets for abuse. They inevitably blow up. This happened with CDOs. And it happened with the Libor rate. The question is how to fill the continuing need in the marketplace?
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Libor was invented in the 1980s to satisfy the financial sector’s need for a private-sector, virtually risk-free interest rate to serve as a benchmark. Banks had discovered the risks inherent in setting a long-term fixed interest loan rate.
The markets could rise and leave them stuck paying an interest rate well above market with eroded loan values.
Short-term loans would resolve that issue but borrowers did not want to get blindsided by an unexpected repayment bill on what was supposed to be a long-term loan.
With Libor, a long-term loan could be issued whose interest rate would be periodically reset. If a bank charged an interest rate a few percentage points above the Libor rate, it would earn a decent risk premium and would be effectively shielded from fluctuating market rates.
By using the rate, banks would be able to make long-term loans practically risk free and that there was a way to actually calculate the Libor rate. Like almost all assumptions, these turned out to be wrong.
The Libor rate is set based on daily reports from banks on rate they have to pay on loan maturities ranging from overnight to 12 months utilizing 10 different currencies.
The scandal that banks were manipulating the rates in their favor might never have seen daylight if an external regulatory body had not taken a look. The Commodity Futures
Trading Commission (CFTA) noticed a difference in trading costs of credit-default swaps on debt issued by major banks while the banks reported little variance at all.
A competing indicator, the Euribor, consistently showed higher rates than Libor. This week, the three-month US dollar Libor rate was .36% and the Euribor was .61%. That means the manipulation is still going on.
CFTA chief Gary Gensler thinks the Libor should be replaced by an indicator based on observable market transactions. The markets need floating rate loans and floating rates require a benchmark. So the issue goes far beyond
the lawsuits and new regulatory practices.
The foundational question is how do we end up with a benchmark rate that is based on reality when that reality is, a fiction.