Must read: Libor Demystified
July 12, 2012
An op-ed entitled Libor Demystified ran in both the National Post and the WSJ this week. It is the best analysis on the scandal I’ve read thus far.
Drawing on parliamentary testimony given by Paul Tucker (deputy governor of the Bank of England), the comment pinpoints the roots of the scandal in an important change in how Libor was being interpreted by the markets. The anonymous author points out that “Libor was conceived in the 1980s as an indicator of the cost of short-term funding for highly rated banks“. By 2007, however, “Libor was just starting to be viewed as a measure of financial stress“.
[A]s Mr. Tucker explained Monday, its role changed in 2007 as the financial panic started to bite. “It became,” in Mr. Tucker’s words, “a measure of something else” – specifically, of the difficulty that those same banks were having in raising money. It was in this unanticipated role that Libor caught the attention of regulators on both sides of the Atlantic during the panic.
Libor is a classic story in which a readily available and modest metric gets adapted for a financially sophisticated purpose by the markets. We’ve seen this before. For example, neither AAA ratings nor FICO scores were originally engineered as indicators of ‘risk’ (‘financial stress’) in any broad based sense of the term, yet both have evolved to serve that function.
The controversy over the effects of Libor manipulation will definitely have legal and material effects, and I would resist this op-ed’s cavalier and technologically determinist conclusions. The author is all but certain that “Libor will be refined or replaced with something more verifiable or transaction-based“. But I would mark this statement as an important heads-up on where this controversy is heading in the long run.
Finance gets driven forward when ‘technical’ solutions are proposed as inevitable solutions to ‘social’ problems. Are the gentleman bankers engaging in ungentlemanly conduct? Then replace them with a better information system!
The Libor scandal raises an important challenge to the information infrastructure of capital markets. It may well trigger a wave of technical innovation that will be both deep and permanent.