The admission comes by way of Andrew Bailey, head of Britain’s Financial Conduct Authority. He said recently (emphasis mine):
“The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks. If an active market does not exist, how can even the best run benchmark measure it?”
As a few Wall Street analysts have quietly noted in the weeks since those comments, an “absence of underlying markets” is a fancy way of saying that LIBOR has not been based on real trading activity, which is a fancy way of saying that LIBOR is bullshit.
LIBOR is generally understood as a measure of market confidence. If LIBOR rates are high, it means bankers are nervous about the future and charging a lot to lend. If rates are low, worries are fewer and borrowing is cheaper.
It therefore makes sense in theory to use LIBOR as a benchmark for borrowing rates on car loans or mortgages or even credit cards. But that’s only true if LIBOR is actually measuring something.
Here’s how it’s supposed to work. Every morning at 11 a.m. London time, twenty of the world’s biggest banks tell a committee in London how much they estimate they’d have to pay to borrow cash unsecured from other banks.
The committee takes all 20 submissions, throws out the highest and lowest four numbers, and then averages out the remaining 12 to create LIBOR rates.
Theoretically, a fine system. Measuring how scared banks are to lend to each other should be a good way to gauge market stability. Except for one thing: banks haven’t been lending to each other for decades.
Up through the Eighties and early Nineties, as global banks grew bigger and had greater demand for dollars, trading between banks was heavy. That robust interbank lending market was why LIBOR became such a popular benchmark in the first place.
But beginning in the mid-nineties, banks began to discover that other markets provided easier and cheaper sources of funding, like the commercial paper or treasury repurchase markets. Trading between banks fell off.
Ironically, as trading between banks declined, the use of LIBOR as a benchmark for mortgages, credit cards, swaps, etc. skyrocketed. So as LIBOR reflected reality less and less, it became more and more ubiquitous, burying itself, tick-like, into the core of the financial system.