Tuesday, 25 April 2017
The Libor witch hunt
Since I wrote my post about the Bank of England's alleged manipulation of Libor before and during the financial crisis, something of a witch hunt seems to have developed. Certain people with axes to grind have jumped on the bandwagon set in motion by the BBC's Andy Verity and are aggressively promoting their view that the Bank of England's behaviour was fraudulent. Their argument is that the Bank of England has no business attempting to influence market rates, that those at the Bank who did this should be brought to justice just as traders who rigged Libor have been, and that businesses, households and public sector bodies that lost money when the Bank of England "talked down" Libor should be compensated.
This is arrant nonsense. Influencing market rates is what central banks do. It is called monetary policy, and it is the means by which they control inflation. If central banks could not legally influence market rates, monetary policy as we know it would be impossible.
To explain this, let's look at how monetary policy worked before the financial crisis. Prior to the era of QE and excess reserves, the principal tool that the Bank of England used to control inflation was the cost of funding for banks. If inflation expectations started to rise, the Bank of England would increase the cost of funding for banks, forcing them to raise the interest rates on loans and thus dampening consumer and business appetite for credit. When credit appetite is dampened, spending into the economy slows and inflation starts to fall. Conversely, if inflation expectations appeared to be drifting below target, the Bank of England would cut the cost of funding for banks, enabling them to cut interest rates on lending and thus stimulating demand for credit. Increased demand for credit would lead to higher spending in the economy, pushing inflation back up towards target. This is of course a much simplified explanation, and leaves out the considerable role of asset markets in interest rate management, but it will do for my purposes here.
The Bank of England's policy rate, known as the "bank rate" or "base rate", is the rate at which it will lend to banks against good collateral. But banks don't generally get their funding directly from the central bank - indeed approaching the central bank for funding carries a stigma, as the fate of Northern Rock showed all too clearly. Banks get their funding from each other, either directly or via money markets. Libor is the rate at which banks will lend to each other. Prior to the crisis, borrowing on the interbank market - unlike borrowing from the central bank - did not require collateral. So Libor was usually a few basis points above the policy rate, reflecting the higher risk that banks take when lending unsecured funds.
But it was important that Libor responded to changes in the policy rate. If it did not - or if it diverged wildly - monetary policy could not work. For example, suppose that the bank rate was 4% and Libor was 4.25%. To calm down rising inflation expectations, MPC raises bank rate to 4.5%. But what if the Libor panel banks submitted funding rates that collectively kept Libor at 4.25%? Clearly, if this happened, the increase in bank rate would have no effect on the cost of funds for banks. The Bank of England would have lost control of its main means of controlling inflation. It would be hardly surprising, therefore, if the Bank deliberately influenced the Libor submissions of panel banks to ensure that Libor remained closely coupled to the bank rate. After all, the Bank is responsible to the Government for ensuring that inflation remains under control. So monetary policy must work. Central banks influence market rates to make sure that it does. There is nothing fraudulent about this, no-one needs to be jailed for it and no-one deserves compensation for it. The witch hunters are barking up the wrong tree.
This is bad enough. But there is a much worse scenario - and unlike my previous example, this one actually happened. Suppose that the bank rate is at 5%, but due to a market panic, Libor suddenly shoots up, to 25% or more? If the Bank of England took no action to bring down that rate, it would be negligent. Interbank funding rates at those levels are a heart attack for banks. Lending into the economy would come to a sudden stop, and the interest rates on variable rate loans linked to Libor would head for the moon, with disastrous consequences for businesses and households. Central banks are responsible for protecting the economy from major shocks like the failure of Lehman Brothers. They do so by influencing the behaviour of financial markets, including the path of key market rates. So of course the Bank of England capped the exponential rise of Libor after the failure of Lehman. It had no choice but to do so. I am frankly appalled at the witch hunters' claim that doing so was fraudulent. Verity, fortunately, has stopped short of making such a ridiculous accusation.
Since the financial crisis, the excess reserves created by QE have partly emasculated the bank rate as principal policy tool, and the interbank market is much reduced as market participants now prefer to lend against collateral. Now, repo rates are probably of more concern to the Bank of England than Libor. But perhaps, at some point in the future, excess reserves will have drained away sufficiently for monetary policy once again to be effectively transmitted via bank funding costs, and market participants will feel secure enough to lend unsecured. When that happens, Libor will return to prominence - and central banks will try to influence it. That is their job.
The Bank of England was in no way wrong to influence the path of Libor, or of any other market rate, in the pursuit of monetary policy objectives. Where it went wrong was in failing to be open and transparent about targeting Libor as a secondary policy rate. Lying to Parliament about the conduct of monetary policy is never justifiable. And nor is allowing others to lose their jobs and/or be jailed for acting on the Bank's instructions.
We need to distinguish clearly between manipulation of Libor by commercial banks and traders to flatter their own positions, and manipulation of Libor by commercial banks guided by the Bank of England in order to meet monetary policy objectives. Until that distinction is made, we cannot know whether the likes of Tom Hayes are innocent or guilty. There may have been a miscarriage of justice - or there may not.
The Bank of England must come clean about the extent to which it manipulated Libor, and why. There is no shame in being honest: indeed failing to tell the truth risks fatally undermining its credibility. The public deserves to know that when central banks are doing their job properly, there is really no such thing as a market rate.
And the Libor witch hunters must back off. Their antics are not helpful.
Libor and the Bank
Image: "Salem witch hunt begins" from www.history.com