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:— Charles Dickens, ''Oliver Twist''}} | :— Charles Dickens, ''Oliver Twist''}} | ||
==== 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. | ||
Since banks ''borrow'' in floating and ''lend'' in fixed | Since banks ''borrow'' in floating and ''lend'' in fixed, they have “''structural'' interest rate risk”. It flows naturally as a 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, a foundational question: How to determine the floating rate, day to day? | So knowing what that floating rate is, and managing it, is an important function. So, a foundational question: How to determine the floating rate, day to day? | ||
Enter, lifetimes ago, 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 | Enter, lifetimes ago, 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 | 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. | ||
You get the picture. | |||
With LIBOR published, the banks could then set the rates for their deposits and calculate a suitable fixed rate for new term loans. Happy, dull stuff, carried out by happy, dull people: look: we don’t want to run the interest rate-setting world down, but before 2007, this 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 ==== | |||
As per the basic 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]]<nowiki/>s. | |||
Here, the bank “swaps” interest rates with individual (large) customers: it might, for an agreed period, pay one customer a fixed rate and receive from it a floating rate; with another it might pay floating and receive fixed. | |||
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. | |||
We can see in any case that, notwithstanding the bank’s structural interest rate risk, a swap trader who is, net, “long” floating rate wishes floating rates to go higher. If her position is large enough, so might the whole bank. | |||
This prospect, we venture, was not wildly present in the minds of the Sir Bufton Tuftons who formulated the LIBOR rules defining how submitting banks should choose the rates they submit each day. | |||
It is one of JC’s [[Financial disasters roll of honour|axioms of financial scandal]] that [[Air crashes v financial crashes|''calumny happens where you least expect it'']]. This is because success in financial services is in large part about “[[edge]]”, and you find the most [[edge]] where no-one else is looking. In the lead up to the global financial crisis, no-one was looking very hard at LIBOR. | |||
Tom Hayes was a cool kid (''metaphorically'': he doesn’t seem to have been very ''literally'' cool at all). But he hung out in the chess club. He, and a bunch of other groovers, found some edge there, where no one was looking for it. No one bothered them and they didn’t do any harm — at least, not that anyone has been since able to point to. But they sent each other lots of [[embarrassing emails]]. In any case, they made an effort to submit LIBOR rates that suited their derivatives trading books and not, necessarily, the bank’s structural interest rate position. | |||
The question arises: when submitting a rate, what account can you take of your bank’s derivatives trading book? | The question arises: when submitting a rate, what account can you take of your bank’s derivatives trading book? |