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LIBOR rigging: Difference between revisions
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== Bedtime stories: LIBOR and other animals == | == Bedtime stories: LIBOR and other animals == | ||
Skulduggery in the LIBOR submission process was not the only saucy carry-on in the interest rate market. For something that is meant to be dullsville, after school chess club was quite the hotbed. | |||
Take the business of lending to small and medium enterprises. | |||
What follows is not authenticated history, but something more like a fable or a [[Just so story|“just so” story]]. A bedtime story. The actual facts of any particular case might differ, but it stands as a simple device to paint a general picture. | |||
Bear in mind what the businesses of middle England want from their banks: finance, for a predictable term, at a predictable cost. | |||
And remember, in the good old days — specifically before [[Swap history|1981]] — if you wanted “exposure” to an interest rate, you had to actually borrow, or lend, money. But England’s businesses didn’t want “exposure to interest rates”. They wanted ''money''. Capital. Indeed, before 1981 the idea of “isolated exposure to interest rates” would have seemed more or less incoherent, the same way a shadow seems incoherent, without the boy who cast it. | |||
This was | Interest came with a loan, and how it was calculated depended on its ''term:'' if you wanted your money back at any time without penalty, there was no “term” — well: strictly speaking there was, but it was ''overnight'' — and your interest rate could therefore “reset” every day. If you didn’t like the new rate, you could take your money away, or pay it back, without penalty. Hence, interest on call deposits (and [[Revolving credit facility|revolving credit facilities]]) is calculated by reference to a floating rate. | ||
If you wanted to lend or borrow for a set term, you could lock in a fixed interest rate for that term — but you couldn’t have your money back, or voluntarily repay it, before that term, either, without incurring a “[[Breakage costs|funding break cost]]”. | |||
We can see here that interest rate “risk” sits with the bank: it is funding the customer’s loan from its own borrowing — that’s what banks do — and if the cost of that borrowing rises or falls, the bank loses or gains. | |||
This is how it ought to be: banks are the financial experts. They have the size, scale, expertise, information and position to manage their interest rate risk. The caravan parks of Middle England are better spending their energy managing, well, caravan parks. | |||
The great financial innovations of the 1980s led bankers to see their liabilities in a whole new way. A fixed rate loan was a funded credit derivative with an embedded interest rate swap. | |||
This was all well and good — you ''could'' see it that way, and with derivatives, you could certainly manage your risk that way — but bankers were still left with the rather unitary problem that their interest rate risk was buried intractably in a term loan. | |||
What if, wondered the bankers, we separated them? We could offer our customers floating rate loans and sell them interest rate swaps, under an ISDA, by which they can convert those floating rates | |||
At about the same time, Britain’s commercial bankers were having fun at the hands of the caravan parks, flying clubs and property investment consortia of middle England. The [[interest rate swap mis-selling scandal]] is a many-headed hydra — it turns out most commercial banks in the UK had hit upon variations on the same idea independently of each other and then jammed it down middle England’s gizzard, but the gist was this: rather than just offering them straightforward loans, banks would offer floating rate loans stapled — loosely — to complicated hedging products. | At about the same time, Britain’s commercial bankers were having fun at the hands of the caravan parks, flying clubs and property investment consortia of middle England. The [[interest rate swap mis-selling scandal]] is a many-headed hydra — it turns out most commercial banks in the UK had hit upon variations on the same idea independently of each other and then jammed it down middle England’s gizzard, but the gist was this: rather than just offering them straightforward loans, banks would offer floating rate loans stapled — loosely — to complicated hedging products. | ||