"Des waerelds doen en doolen, is maar een mallemoolen,"

"Des waerelds doen en doolen, is maar een mallemoolen," engraving from Het Groote Tafereel der Dwaasheid, 1720.

"The actions and designs of the world go round as if in a mill." South Sea bubble financial crisis.

Tuesday, March 27, 2012

The economic and social importance of the LIBOR

The allegation of LIBOR manipulation by some banks offers one the opportunity to ponder on the importance of that single number. Donald MacKenzie gave the following figures in 2008:
Judged by the amount of money directly dependent on it, the British Bankers’ Association’s London Interbank Offered Rate matters more than any other set of numbers in the world. LIBOR anchors contracts totalling around $300 trillion, the equivalent of $45,000 for every human being on the planet [...] For instance, the level of LIBOR determines the monthly payments on around half of the adjustable-rate mortgages in the US: rates are set as LIBOR plus a fixed margin and reset periodically at LIBOR changes [...]  LIBOR is even more central to the huge market for interest-rate swaps.
The process of its calculation rest on a conditional question asked to banks however. That is, at which rate each bank "could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 11.00. " (11.00 being the time each bank has to submit their rate). The flaw in this process is obviously the jugdement of what a bank could do, instead of what it has done. But the risk of manipulation is thought to be mitigated by the fact that that manipulation would have to take place in the public arena, since the inputs of the LIBOR are highly scrutinized. So a banks lowering artificially its rate while others wouldn't would be spotted easily and risk exclusion from the panel.

So in order to manipulate the rate to profit from the derivatives contract connected to it, for example, banks must cooperate.

And they seem to have just done that. 

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