Thursday, June 12, 2008

Fixing Libor, Redux

(Felix Salmon) The FT's Lombard column asks a good question today: Why is Libor used as a basis for US loans in the first place?

Dollar Libor started life three decades ago as a "eurodollar" index - meaning it was mostly used by international banks trading in London. But in the past decade, the index has been used as the benchmark for a mountain of domestic US contracts. In good times, nobody noticed this discrepancy (and the BBA simply enjoyed the boost to its brand), but now the pitfalls of basing so much domestic US activity on an index compiled in London have been laid bare.
This problem could be solved by creating a new US-focused dollar index, perhaps set during New York trading time with US banks.

Of course, there is now such an index - NYFR. We'll see whether it takes off or not. But the idea behind it makes sense. Remember why eurodollars began in the first place, in the late 1950s: the Soviet Union was worried about expropriation risk on its dollars in New York. Later, in the 1960s, the eurobond market emerged as a "pure" bond market: because the money was all lent and borrowed outside the US, there was no way of it becoming subject to US taxation or other regulation.

Nowadays, the US neither has capital controls and nor is there much of a risk that it will impose them in future. But there is still a difference between onshore and offshore dollars, and it makes sense to peg onshore loans to an onshore index rather than a eurodollar index.

That said, however, I'm not entirely clear why such an index should necessarily be based on interbank lending rates. There are alternatives: not just eurodollar rates (which wouldn't solve this particular problem) but also domestic CD rates - the rate at which banks fund themselves in the CD market. Explain Stanford's John Taylor and the San Francisco Fed's John Williams, in a recent paper:

The argument is that banks are reluctant to lend funds in the inter-bank market because of uncertainty about their own future need for funds, perhaps because of concerns about risk in their own balance sheet. We referred to this phenomenon as "liquidity risk" in our earlier paper.
One way to discriminate between liquidity risk and counterparty risk is to look at rates paid when parties other than banks lend to banks, as in the market for certificates of deposit. As long as lenders exist who are not constrained by liquidity concerns, banks who seek to hoard liquidity can borrow from these lenders in the CD market.

Taylor and Williams find that "CD rates have tracked Libor and other inter-bank term lending rates closely during the crisis, except for a few notable episodes, suggesting that liquidity risk is not a significant separate factor driving term lending rates." But those notable episodes include a large chunk of this year, especially in the longer-maturity 3-month Libor rate.

Maybe the answer here is to add commercial lenders to the Libor mix: include the CD rate as another input, since it is ultimately a bank funding rate. After all, the key reason for using Libor in the first place is that it represents banks' wholesale unsecured funding costs: the fact that it's an interbank rate is largely incidental.

(Thanks to Darrell Duffie for pointing me to the Taylor paper. And thanks to Padraig Fallon for forcing me to learn the history of the euromarkets back when I started at Euromoney in 1995: I knew it would come in useful one day!)

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