Catching up on last week's Economist this morning I found another example of financial buffoonery that boggles the mind. The article is online: Inter-bank interest rates; Cleaning up LIBOR -- A benchmark which matters to everyone needs fixing:
It is among the most important prices in finance. So allegations that LIBOR (the London inter-bank offered rate) has been manipulated are a serious worry.
LIBOR is meant to be a measure of banks’ own borrowing costs, and is used as the foundation for a host of other interest rates. Everyone is affected by LIBOR: it influences the payments made on mortgages and personal loans, and those received on investments and pensions.
Given its importance, the way LIBOR is calculated is astonishingly flimsy. LIBOR rates are needed, every day, for 15 different borrowing maturities in ten different currencies. But hard data on banks’ borrowing costs are not available every day, and this is the root of the LIBOR problem.
The British Bankers’ Association (BBA), responsible for LIBOR, gets around it by asking banks, each day, what they feel they should pay to borrow.
So LIBOR rates—and the returns on $360 trillion of financial contracts related to them, five times global GDP—are based on best guesses rather than hard data.
Let that sink in and forget about what you learned in business school or economics classes. LIBOR isn't based on actual rates; it's based on feelings!
The next part of the article talks about suspicions that banks manipulate this broken process to the advantage of the financial sector.
The remainder offers recommendations for improvement:
[T]he BBA should revamp LIBOR to ensure it is simple, transparent and accountable. These principles suggest LIBOR should be based on actual inter-bank lending, with any gaps filled in with the help of statistical techniques. Banks’ own guesses should be used as a last resort, not the first.
And regulators should collect data that could help spot LIBOR cheats: banks should be required to submit information on other banks’ borrowing costs, as well as their own. Regulators could cross-check submissions against hard data on banking-sector risk, and publicly report LIBOR abusers.
Keep this system in mind the next time a so-called "master of the universe" offers a lecture on measuring risk in digital security.