Is the increased gap between Libor and overnight rates a Machiavellian scheme, where liquid banks are forcing up Libor to earn extra cash on products that are indexed against this measure of money market rates? Can the central banks do anything to stop banks hoarding cash and so close the gap? Are the money markets broken? The probable answer to all these questions is no.
Distrust and concern at the level of Libor is understandable. The gap between Libor and overnight rates remains nearer 100 basis points than the 10bp spread seen a year ago. But so what if Libor spreads are at historically wide levels? There are plenty of money market participants that say it doesn’t really matter to them and that they are just trading rates – as they always have.
Navel-gazing over Libor might seem slightly arcane but the problem is real. This measure of money market activity is embedded into the financial system. Some $350 trillion of products are indexed against it, according to the British Bankers’ Association.
Libor is a rate set by a small market with its own vested interests that drives pricing in a vast, far larger universe. It is the proxy for where a double-A-rated bank can fund – and the number of banks that can count themselves as such is declining almost every day.
When Libor was introduced in 1985, it accurately reflected the level at which banks lent to each other. But as time went on, most treasury operations moved away from interbank lending, and into other funding mechanisms. Liquidity in the money markets is relatively thin compared with the term funding markets in which banks really finance their operations, and activity just a fraction of the size of the products indexed against the fixing.
Until the end of the 1990s the overnight index swaps/Libor spread averaged 25bp. It was only after the Alan Greenspan-induced hyper-liquidity of the past decade that this gap collapsed to 8bp to 10bp. That state of affairs was, in reality, as far from normal as today’s is abnormal.
Finding a new benchmark might be possible but at present all options have serious drawbacks. Transparency is key. All players should now be fully aware of Libor’s inherent weaknesses. Financial contracts that reference it should be adjusted, where necessary, to reflect recent volatility and its elevated level.
But maybe a complete rethink of the system is needed. For years, the US traded on an actual yield basis. It is only recently that Libor spreads have become so prevalent in New York as a benchmark. What is more transparent than a simple yield rate?