Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Doubts on LIBOR

Yesterday’s Wall Street Journal has a story
about bankers questioning the reliability of Libor. Last month, the
BIS Quarterly Review discussed the issue at length with lots of data
and some amount of econometrics:

Gyntelberg and Wooldridge find that: “The US dollar market
stands out for being the one market where Libor rose by substantially
less than similar fixings during the stress period. The average spread
between Sibor and Libor widened from about zero in the normal period
to 2 basis points in the stress period, and the spread between H.15
and Libor widened from -1 to 7 basis points.” Of these, Libor is
the only one that is used as a reference rate for swaps and other
derivatives while H.15 (named after the table number in which the
Federal Reserve publishes the data) is the only one which is based on
actual transactions.

Since H.15 was 7 basis points above Libor, it does confirm that
banks were actually paying more than what the Libor panel was quoting
during the Libor fixing. Though 7 basis points is not a trivial
difference when trillions of dollars of debt is referenced to this
rate, it is much less than the 30 basis points being mentioned in the
WSJ article. Moreover, there is a different way of looking at whether
Libor is too high or too low and that is by comparing it to the
Overnight Index Swap based on overnight rates. Under the expectations
hypothesis, the OIS and Libor must be equal. Michaud and Upper find
that during the crisis, Libor exceeded the OIS by 50 to 90 basis
points. From this perspective, the problem is that Libor was too high,
not that it was too low.

Gyntelberg and Wooldridge re-estimated Libor using a bootstrap
technique instead of the trimmed mean used by the BBA and found that
the bootstrapped estimate is not significantly different from Libor.
“Moreover, the 95% confidence interval around the bootstrapped
mean loosely corresponds to the interquartile range in the Libor panel
… In other words, the bootstrap technique indicates that 19 days out
of 20, the design of the Libor fixing produces an estimate that is
close to the true interbank rate. This is the case even during the
stress period.”

They also argue that “many of the banks on the US dollar
Libor panel are also on the euro Libor panel, and there are no signs
that signalling distorted the latter fixing.” I do not find this
argument convincing because Chapter 2 of
the same issue of the BIS Quarterly Review provides a chart on page 21
which highlights how lopsided the US dollar interbank market has
become. The data suggest that US banks have raised more dollar
deposits from non banks than they have lent to non banks while the
position is the reverse for European banks. The result is that
European banks have probably borrowed about half a trillion dollars
from US banks in the short term inter bank market. In times of
heightened concerns about counter party risk, positions of this size
become difficult to roll over and poses huge systemic risk. The
incentives for strategic quoting are much higher in the dollar market
than in the euro market.

All this has a bearing on the common assumption made in recent
years in the credit derivative market (both in the theoretical
literature and in the practicing world) that the correct risk free
rate is the swap rate (essentially Libor) and that the TED spread is
essentially a liquidity premium and not a credit spread. Since the
crisis of 2007 and 2008 is simultaneously about liquidity and about
counterparty risk in the inter bank market, all the turmoil fails to
throw light on this hugely important issue.

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