LIBOR's Saga Concludes

My first job as an economist was in litigation consulting, digging into the data in a lawsuit to determine the veracity and consequences of allegations of illegal behavior. And when the LIBOR matter arrived at our firm, I couldn’t believe the claim. Was it possible that a core component of the financial system had been manipulated? As I dug into the data, I witnessed the dispersions: LIBOR was not what it claimed to be. And at long last, the prolonged dispute is approaching its final settlement.

In its original form, the London Inter-Bank Offered Rate was a surveyed measure. Each day, a set of bank representatives gave responses to the following prompt: “The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.” At its peak, the survey asked for rates in ten currencies and up to 15 maturities.

The prompt reveals LIBOR’s fundamental problem: it was fiction. Respondents did not need to base their answers on any real transactions, only the rate they claimed they could receive from a counterparty. No evidence was required. Actual trades in many of the currencies and terms were scarce, as most bank funding transactions are conducted overnight.

But market participants did not scrutinize the methodology, welcoming LIBOR as a unique and useful reference rate from which to price any number of transactions. From modest and informal beginnings in 1969, use of the rate grew to a more formal survey panel conducted by the British Bankers’ Association (BBA) in 1986. The BBA conducted the survey of 18 international banks every day. The BBA methodology was a trimmed-mean average: the four highest and lowest observations were excluded, and the average of the remaining submissions became the day’s LIBOR rate. Market participants would then price their bonds, lines of credit and any number of structured finance products using a spread to LIBOR.