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.

2 Responses to “Must read: Libor Demystified”

  1. Anchard Says:

    David Warsh of the blog Economic Principals has a similar take to yours, which in his case builds on Mokyr’s writing about institutions. The link is here:
    http://www.economicprincipals.com/issues/2012.07.15/1393.html

    I also agree that there is a much bigger question here about the ways in which finance in practice tends to shift indices from their grounding as objective, calculated metrics of a particular phenomenon in order to use them as indicators of much larger patterns. One could also put the VIX into this same basket, or the TED Spread during 2007 – 2008. As you rightly note, this seems to happen most often in cases where calculation requires a measure of ‘risk’ where none exists. Although it is far from exact, there seems to be an analogy between this behavior and the need for instrumental variables in econometrics.

    To your concluding point, I also wonder whether the insistence on using only transactional “evidence” in the creation of these metrics doesn’t introduce a dangerous reflexivity, as calculation by market actors becomes increasingly driven by similar calculation by related market actors. That would seem to increase significantly the risk of information cascades given the reduction in truly new information entering from outside of the calculative space.

  2. Jacques-Olivier Charron Says:

    I would also mention Paul Jorion’s analysis on this affair, that can be read for example at http://www.pauljorion.com/blog_en/?p=824 and also in http://www.pauljorion.com/blog_en/?p=741 (his blog is in French, but most of the posts are now translated). The point I find most interesting in his approach is how it departs from the (most popular) “moral” take on this, that is the “These are villains because they lied”. Jorion explains that, had a bank told the truth about the rates the other banks were demanding to lend it money, it would have put, not only itself, but the entire economy in dire straits, it would have certainly aggravated the global crisis that was unfolding at this time. This is a case where lying can be considered a “national duty”, as Jorion puts it. And this is the case, indeed, because of the way the LIBOR had come to be interpreted, that is, as a global risk indicator. I think a critical approach of finance has to depart clearly from a moral one, and that the sociology of finance (I definitely won’t use the term “SSF”, because it seems too narrowly linked to a specific theory) is the only way to get it. If one has to be critical, one has to identify first what has to be criticized, and in my view it is not the fact that “people lie” but the whole set of practices, devices, interdependencies, hierarchies… that, in the inner workings of financial markets, produce and reproduce instability. As Minsky put it, the greatest challenge to capitalism is not inequality but instability. And again, it is not a question of “truth”: the idea, that lies behind the “moral” approach, that, if everybody had the “right” information at the same time, everything would be all right, is simply not true.


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