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LIBOR rigging: Difference between revisions
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==== Banks have structural interest rate risk ==== | ==== Banks have structural interest rate risk ==== | ||
{{drop|T|he basic model}} of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. ''Generally'' banks calculate interest on deposits, by which they borrow, at a [[Floating rate|floating]] rate and on term loans, by which they lend, at [[Fixed rate|fixed]] rates. | {{drop|T|he basic model}} of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. ''Generally'' banks calculate interest on deposits, by which they borrow, at a [[Floating rate|floating]] rate and on term loans, by which they lend, at [[Fixed rate|fixed]] rates. There is a straightforward reason for this: [[Deposit|call deposit]]<nowiki/>s don’t have a term: they can be withdrawn at any time. All you can do is apply a prevailing daily rate.<ref>You could look at deposits as “rolling overnight term loans”. Their fixed interest therefore resets each day. Yes: there are such things as term deposits, but roughly 70% of deposits are overnight. (see ''{{Plainlink|https://www.bankofengland.co.uk/statistics/tables|Bank of England statistics}}'').</ref> On the other hand, most people who borrow for a fixed term want certainty on how much interest they must pay, so they prefer fixed interest. | ||
Since banks ''borrow'' in floating and ''lend'' in fixed, they have “''structural'' interest rate risk”. It | Since banks ''borrow'' in floating and ''lend'' in fixed, they have “''structural'' interest rate risk”. It is a natural function of how banks work. They want floating rates to be low, and to move lower. If they don’t manage this risk, things can get funky, fast. Just ask [[Silicon Valley Bank]]. | ||
So knowing what that floating rate is, and managing it, is an important function. | So knowing what that floating rate is, and managing it, is an important risk management function for the bank. A risk well managed is called a “return”. The floating rate is different from the central bank’s base rate, and moves daily in response to market conditions: | ||
Enter, | So, a foundational question: Where does this “floating rate” come from? | ||
In the good old days, each bank worked out its own floating rates, based on its own models, funding costs and market positioning. This process was opaque and unstandardised. Rates could vary significantly between similar banks. | |||
Enter, in the nineteen eighties, the [[British Bankers’ Association]]. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. Inasmuch as it ever did anything useful, the BBA compiled the “London Interbank Offered Rate” — “[[LIBOR]]” — sleepily, by inviting 18 major banks to, literally, ''phone in'' the rate at which they believed they could borrow in various currencies and maturities in the market each day. | |||
The BBA would compile the submissions, “trim” off the top and bottom four, average the rest and publish the result as a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and a regular three o’clock tee time. | The BBA would compile the submissions, “trim” off the top and bottom four, average the rest and publish the result as a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and a regular three o’clock tee time. | ||
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You get the picture. | You get the picture. | ||
With LIBOR published, the banks could then set | With LIBOR published, the banks could then set its rates for call deposits, calculate suitable fixed rates for new term loans, by reference to this standardised “benchmark”. Happy, unadventurous stuff, carried out by happy, unadventurous people. Look: we don’t want to run the interest rate-setting crowd down, but before 2007, the LIBOR rate setting process was the after-school chess club: all the cool kids were out shagging, smoking weed and shorting structured credit. No-one cared much about LIBOR. | ||
==== Interest rate derivatives ==== | ==== Interest rate derivatives ==== | ||
{{drop|A|s per the}} “basic banking model”, to manage their structural interest rate risk, banks ''generally'' would want LIBOR low — but deposits are not the only show in town. Banks have other exposures to the interest rate market. One notable category: [[Interest rate swap mis-selling scandal|interest rate swap]]s. | {{drop|A|s per the}} “basic banking model”, to manage their structural interest rate risk, banks ''generally'' would want LIBOR to be low — but deposits are not the only show in town. Banks have other exposures to the interest rate market. One notable category: [[Interest rate swap mis-selling scandal|interest rate swap]]s. Swaps [[Swap history|emerged as an asset class in the early 1980s]], and there is a good argument to be made that LIBOR — instituted in 1986 — was a direct response to the burgeoning interest rate swaps market, which could only work if floating rates were standardised. | ||
In an interest rate swap, the bank exchanges — swaps — interest rate cashflows with individual counterparties: it might, for an agreed period, pay one counterparty a fixed rate and receive from it a floating rate; with another it might pay floating and receive fixed. | |||
Unlike basic banking, there is no structural bias to swap trading. If a bank swaps a five-year fixed rate for a five-year floating rate, and LIBOR goes up, by definition the bank profits: the “[[present value]]” of its incoming floating rate will increase while the [[present value]] of its outgoing fixed rate stays the same. The dealer is therefore “[[in-the-money]]”. If it swapped floating for fixed in the same case, it would book a loss. | |||
While banks try to balance their books so their customer swaps offset each other as far as possible, how they “position” the book might help manage the bank’s ''structural'' interest rate risk. | While banks try to balance their books so their customer swaps offset each other as far as possible, how they “position” the book might help manage the bank’s ''structural'' interest rate risk. | ||