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.

Related reading:

Libor and the Bank

Image: "Salem witch hunt begins" from www.history.com


  1. So, according to you, the Bank of England was doing nothing wrong when it supposedly asked banks to lie in the LIBOR submissions.

    The submissions were meant to be truthful and other market participants rely on them, but, according to you, that does not matter.

    Your reason is that the Bank of England supposedly was secretly targeting LIBOR as part of its monetary policy.

    That is a curious explanation.

    First of all, the idea of targeting an indicator, is to use that indicator as a signal and steer policy accordingly.

    The idea is not to corrupt the signal in order to mislead market participants.

    Second, the Bank is alleged to have encouraged false submissions at the request of the Treasury.

    If so, your defence does not apply.

    1. You have entirely missed the point. The indicator is not just the signal, it is also the tool. If monetary policy cannot influence market rates, it is impotent. Saying that the Bank of England should not have ensured that Libor remained coupled to the base rate is in effect saying there should be no monetary policy.

      You also forget that the central bank is the lender of last resort. As a last resort, if banks cannot fund themselves in the market, they will borrow from the central bank at whatever rate it sets. Their Libor submissions would therefore truthfully be the rate the central bank charges them, not the "market" rate. In the crisis, this was the case for several of the panel banks, including RBS, HBOS, UBS and WestLB. They did not have a "market" rate at all. That in itself was sufficient to distort Libor, even without the huge market dislocations that were sending interbank funding rates to the moon and forcing even solvent banks to borrow from central banks. Libor really can't be considered to be in any way a "market" rate during the financial crisis.

      The Bank is accountable to the Treasury for the effectiveness of monetary policy. In the crisis, they worked closely together.

      I specifically said that the Bank should have been transparent and open about its targeting of Libor, and that it should now come clean about its involvement.

    2. Three choices.
      a) Encourage banks to submit honsestly.
      b) Encourage banks to submit dishonestly.
      c) Encourage banks to submit dishonestly but tell the world that they are doing so.

      You recomment c). The drawback of that is that lying about something and admitting it is pointless (except for day time TV particpants) and would open the Bank to legal action.

      The only sensible choices are to tell the truth or lie and not get caught.

  2. I'm sorry Frances I'm completely missing your point as well. The BoE has no business at all interfering with LIBOR.If banks cannot trust each other enough to lend to each other, yes the BoE must step in and provide said funding. There were countless options open, eg suspending libor, forcing funding upon all banks, regardless of needs a la fed, anything but what they did.

    I know you don't agree with my POV on this but I'll state it once again for discussion purposes only. Those at the top of high finance have stopped believing that the rule of law does not apply to them. To protest now that they "had no choice" or "I wuz just doin' me job guv" does not hold water. They are called mitigating circumstances.

    The BoE could have requested emergency legislation to help them cope with a system clearly unfit for purpose but they didn't. My conclusion can only be they don't think the law applies to them and they can break it with impunity whenever they choose to do so.

    And they did choose to do so. bill40

    1. I'm sorry, this is simply unrealistic. Have you ANY idea how long it takes to get "emergency legislation" through both Houses of Parliament? What do you think the effect on the economy would have been if the Bank of England was unable to do anything until MPs and Lords had finished deliberating?

      No doubt there were other things that could have been done. But influencing market rates is what central banks do. I don't understand why you - and others - find this such a difficult concept to grasp. If the policy rate does not influence other rates, as it did not in the crisis, monetary policy can have no effect. Therefore, central banks must at times directly influence market rates. Monetary policy must work at ALL times, not just when things are calm.

      I don't agree with your analysis and I don't agree with your conclusions.

    2. Why do you call the false reporting of interbank lending 'influencing market rates'?

  3. The post, as it is written, is non sense. the BoE can set the boe bank rate and it can seek to affect Libor, but telling banks to lie about libor is not governance and it does not achieve the the policy goal as the banks will be interbank lending at a different rate.

    1. I agree that telling banks to lowball Libor was not the best way of influencing the rate. I suspect that had the Bank of England been transparent about its targeting of Libor, it would not have needed to tell individual banks to lower their submissions: it could simply have issued forward guidance to the market as a whole. It is unfortunate that they used the method that they did, but that does not mean the motive was wrong. There is a world of difference between manipulating Libor for commercial profit, and influencing Libor for monetary policy. I really, really wish readers of this post could grasp this fundamental distinction.

  4. LIBOR is an estimate of a rate that banks lend to each other (banks don't lend each other non-collateralised long dated fixed term cash anyway), as such, by the t&c of LIBOR they were expected to publish a rate that they felt they could receive in the market to fund their balance sheet, if required. LIBOR IS NOT A CENTRAL BANK RATE! The Central Bank, should it wish, has many ways to influence that rate and did eventually add liqudity to the system. To ask a Bank to lie about actual borrowing costs, if that is what they did, is wrong, pure and simple. It should be noted that BOE was also allegedly targetting $ LIBOR (not it's own currency) at a UK Bank to protect the perceived credit worthiness of their own domestic institution. If this is proven it was simply wrong. It should also be noted that the trader who followed senior orders at Barclays is now in jail whilst the people who asked him to do so are not.
    Wrong from start to finish!

  5. I love your writing, Frances, but I think you're slightly off the mark here.

    The reason BoE sought to influence Libor in late 2008 was because it was being used as a portmanteau for liqudity conditions and market stress. In partiuclar, the Libor submissions of individual banks were being used as a measure of their health, and of the likelihood that they might need bailed out.

    At that time, the BoE couldn't give two hoots that Libor wasn't tracking the base rate. They just wanted to make sure that no single bank was an outlier.

    Even if the BoE's intentions had been to align Libor with base rate, success in that endeavour would not have 'fixed' the monetary policy transmission mechanism as you suggest because, as I'm sure you know, [emphasis] Libor was a survey not a traded rate (hence its vulnerability to manipulation).

    Aligning Bank rate with Libor would have been a Potemkin process that did nothing for the effectiveness of monetary policy because underlying conditions in interbank
    funding markets would not have changed.

    The BoE's involvement in Libor manipulation had nothing to do with monetary policy and everything to do with financial stability, and trying to avoid "unnecessary" state recapitalisation.

    That said, I totally agree with your conclusion. This is totally different, ethically, from fraudulent manipulation to improve trading positions. Should the Bank come clean? That would be helpful. Should people be compensated? Probably not. Should it change our or the courts' assessment of traders who were involved in fraud? Of course not.

    1. I disagree with your conclusion...it essentially amounts to exactly the same thing, both ethically and legally. Barclays plc is a publicly traded company and to falsify it's ability to receive credit in the market by lowballing would have an effect on it's true share price as it falsifies the Bank's actual wellbeing....this is certainly no better or more justifiable than improving trading positions and totally unaligned to the intentions and t&c of the LIBOR setting process.

    2. Anonymous 1,

      There is evidence that the Bank was routinely influencing Libor prior to the financial crisis. This would not have been for financial stability reasons, as if you recall Mervyn King did not take his financial stability responsibilities seriously, believing that inflation targeting would do it all for him. So it would have been monetary policy.

      I agree that Libor capping during the crisis would have been primarily for reasons of financial stability. I didn't make that distinction in the post, but I did refer to exponential Libor increases being a heart attack for banks.

    3. Anonymous 2,

      I think I have made it clear already that in my view the capping of Libor in the financial crisis had little to do with bank share prices and much to do with preventing a financial system meltdown with disastrous consequences for the economy. Frankly, in a crisis like that, the share price of Barclays is fair game, as is any other market price.

  6. No offence but you seem to miss my point which is that LIBOR is an interbank lending rate from a panel of commercial banks, not a central bank lending rate. The BOE had no remit or right within the terms of the BBA t&c to ask banks to falsify that rate if it is proven that is what they did....as there would be consequences that would create a false market....in this case an overinflated share price. You may recall that when Barclays admitted tampering with LIBOR it was fined and it's shares went down.
    The correct tool that central banks use in such a crisis is to simply add liquidity which would then take care of LIBOR as a commercial bank, flush with cash, would then automatically lower it's rate. That is what happened in the end anyway.
    To falsify LIBOR, by the law of the land, is wrong whether it be by a trader attempting to bump up his profit, a Commercial Bank exec requesting such a move, or a Central Bank doing the same. There can't be one law for one and one for another, if there was there would be no rule of law. Anonymous 2

    1. No offence but you are missing MY point. The central bank can legitimately target any rate, whether or not it is "officially" a central bank rate, in pursuit of monetary policy objectives.

      During the crisis, supplying liquidity could not - and did not - bring the rate down. Nor could the rate reflect true funding costs at that time anyway. Many of the panel banks were shut out of markets. Their market funding costs were effectively infinite. What they submitted was the rate that the central bank charged them for emergency liquidity.

      I suggest you stop digging now. A central bank influencing Libor for monetary policy and/or financial stability reasons is a totally different matter from a commercial bank manipulating Libor submissions to flatter its own profits. There can indeed be one law for one and another law for the other - and indeed there should be. If the same law was applied to both, despite their fundamentally different motivations, there would be no rule of law.

    2. Rule of law implies that every citizen is subject to the law, including lawmakers themselves. In this sense, it stands in contrast to an autocracy, dictatorship, or oligarchy where the rulers are held above the law.

    3. The law says manipulating Libor for personal or corporate profit is fraud. It has nothing to say on influencing Libor in pursuit of a monetary policy mandate.

    4. No! The law has decided manipulating or falsifying Libor is fraud 'full stop', there is no caveat!
      There is also no reference on the Bank of England website to suggest BOE is 'mandated' to influence commercial Bank setting of Libor as a monetary policy 'tool' as you suggest.
      Take a look for yourself on http://www.bankofengland.co.uk/monetarypolicy

    5. You clearly have not bothered to read my post. Setting the base rate alone is not necessarily sufficient to ensure the monetary policy stance is transmitted through the bank lending channel. The Bank of England therefore has the right to influence whatever market rates it deems necessary in order to ensure the effectiveness of monetary policy. That would include commercial bank Libor submissions.

      I also refer you to my reply to another Anonymous below. As with all criminal prosecutions, the motives of the defendants are important. Traders and banks manipulating Libor for personal gain is a very different matter from a central bank influencing Libor for monetary policy purposes with the good of the economy in mind.

      I called for a judicial enquiry into all of this in 2012, and I repeated that call in my post of two weeks ago.

  7. There is nothing wrong in targeting the level of Libor since as you say this is the level banks lend to each other and should be reflective of Bank Rate. The way the BOE should and previously did this was by adding or draining liquidity from the Money Markets.
    The problem that occurred in the credit crunch was that no bank could or would lend to each other. The collateral they had on their books was plummeting in value affecting the money the banks had available to lend. What the BOE should have done was supply more liquidity to the banks therefore allowing them to shore up their balance sheets and have surplus money to lend to each other and UK businesses to help the economy. This would have stopped the rise in Libor straightaway. However the BOE Governor was so obsessed with moral hazard and not bailing the banks out he would only give surplus liquidity for high quality collateral such as Gilts. This was of no help to the banks since the collateral they needed to fund was not the high quality Gilts they held but the decreasing in value low quality collateral such as ABS or MBS. The BOE eventually took low quality collateral for liquidity but far later in the crisis. This inaction therefore meant Libor in August 2007 started to rise dramatically. Ordering banks to post low Libors to give the impression all was well basically was ineffective and fraudulent. If the BOE took the low quality collateral that the banks could not fund straight away Libor would never have soared and the BOE would not have needed to manipulate the benchmark. We can discuss moral hazard and the right and wrongs of bailing out of banks who have basically lent poorly all day. The crux of the matter is that the BOE failed in its response to the increase in Libor making the wrong decisions in supplying liquidity and the BOE/GOV/FSA panicked when Libor continued to rise. This therefore made them make another wrong decision in ordering banks to lower Libor.

    1. I agree that the Bank of England was too slow to provide liquidity in 2007. But that was not the case in 2008. Supplying sterling liquidity did not bring down the rate after the fall of Lehman. Eventually, the Fed supplying dollar liquidity to banks all over the world, and taking on shadow bank liabilities, did bring rates down.

      I'm very disturbed that so few people commenting on this post seem to understand how severe the market dislocations were in 2008, and how difficult they were to bring under control. At the height of the crisis there were effectively no market rates at all.

    2. I don't know if you are aware, but the money markets froze after Reserve Primary broke the buck in the wake of the fall of Lehman. That's why supplying sterling liquidity to banks - which is all the Bank of England can do - did not help. The freeze was in the shadow banking network, which runs on US dollars. Fed provided swap lines so that the Bank of England and the ECB could provide dollar liquidity to European markets without risking running out of FX reserves.

    3. The investigation into Libor was started by the US authorities not because of a 1/8 bps difference in the rate caused by traders submitting within the market range but by 50-100bps differences caused by lowballing and outside market range submissions. If as you say the BOE had every right in asking banks to falsify their submissions for the good of the financial system why did they not stop the investigation by the US citing these reasons. Tucker and King actually said to parliament they did not ask banks to lowball or that they were aware lowballing had occurred until 2012. The evidence seen recently contradicts their version and means in my opinion they lied to parliament. Lying and asking banks to lie about funding costs is dishonest.
      I agree,that In 2008 because of the negligent way the US handled theLehmans collapse, dollar funding for banks SIV or conduits dried up. The Fed therefore opened up availability to their FX swap lines to more foreign central banks (BOE included) and removed the caps on size available. In fact all the schemes introduced and upgraded by the central banks ie Fx swap line,TAF , TARP, SLS, CGS, LTRO and recapitalization worked in stopping the increase in Libor and started its decline. However we know from an email from Jeremy Heywood to Tucker that the UK government wanted that decline to speed up. This is when the BOE, just like they did in 2007, asked banks to lower their Libor submissions.
      The SFO have now investigated and charged traders for manipulating Libor for profit and making dishonest requests which does include lowballing.The problem is they are finding it very hard to prove traders did profit from these minuscule moves and who it actually effected. In fact the last Barclays trial was purely based on the issue of dishonesty. Since the SFO have deemed lowballing a dishonest act they are now having to investigate the BOE,GOV and FSA.
      The requests from the BOE may have been done with the best of intentions. Traders setting within a range did not believe they were doing anything dishonest and the last jury believed them
      The SFO must charge everyone for dishonesty not just traders or charge no one. The law must be the same for all.

    4. I have made it quite clear that I regard lying to Parliament about the Bank's handling of Libor is unacceptable.

      I fear in your aggressive pursuit of getting traders off the hook by means of a "tu quoque" attack on the Bank of England, you have forgotten how the law actually works. In any criminal prosecution, the motives of the defendants are of paramount importance in the eventual outcome. In the case of fraud, for a prosecution to succeed, there must be an intention to defraud for personal gain at the expense of others. So, a trader or a bank who commits fraud in pursuit of their own profit will rightly have the book thrown at them. But a central bank which commits "fraud" in pursuit of monetary policy objectives with the good of the economy in mind is a very different matter. Clearly, personal gain is not the motive, and although there may be some "losers" there will be a much larger number of households and businesses who benefit from the Bank of England's actions to mitigate the effects of a market panic. I doubt if anyone would even pursue court action, and if they did I think it would be highly unlikely to succeed.

      The question as to whether traders have suffered a miscarriage of justice needs to be resolved on its own terms, not by attacking institutions.

  8. There was never an exact science or calculation to follow when any Libor submitter at the 16 panel banks made their Libor submissions in the 13 different periods for a wide range of currencies to the BBA. They purely had to guesstimate what all the other 15 banks were prepared to lend another panel bank. Straight away this gives a range, generally 5 to 10 basis points (0.05 to 0.10%) as various banks could be long of cash and looking to lend whilst others were short of cash and looking to borrow. This is why banks would then consult their banks positions and take them into account when submitting their Libor submissions. The requests made to the banks Libor submitters imo would have always been for a rate that was within this range, and therefore not a fraudulent rate. Plus after taking into account that the top 4 and bottom 4 rate submissions were excluded and a weighted average was computed from the remaining 8, would have seen little to no consequences (typically 0.0001% move on previous days fix) on the rate or any counterpart with a product fixing to Libor. However the BoE instructing banks to lower the Libor submissions by 50 to 100 basis points (0.5 to 1.0%) had a enormous effect. Because all the panel banks seem to have been complicit, the rate automatically dropped even taking into account the bottom and top 4 rates being expelled etc.. But more importantly the rates were not in a range that panel banks could borrow from one and other, contrary infact as there was a interbank freeze on lending and the Libor rates should have actually have been going considerably higher. Therefore the BoE's requests were fraudulent and not in line with the Libor guidelines set by the BBA. The way Libor submissions had been calculated was unchanged for 20+ years up until the BoE's meddling, and was permitted by regulators and senior directors/managers within the banking industry. No one batted an eyelid. However hedge funds and investment banks were livid has they had made huge trades/bets that Libors would rise due to the interbank freeze on lending/lack of liquidity. This is what provoked the Libor investigation and imo led to the BBA, FCA, BoE (UK government), SFO and the panel banks aligning their efforts to appease the hysteria by scapegoating low level traders as the problem for the Libor scandal, when in fact they actually submitted real rates within a correct range to avoid the investigation exposing their involvement which when taking into account the evidence was fraudulent

    1. You are conflating two entirely different things. Manipulation of Libor by commercial banks and traders to flatter their own profits is fraudulent. We can consider whether traders have been hung out to dry to protect bank management - I would be sympathetic to this argument. But the Bank of England's attempts to influence Libor for monetary policy and/or financial stability purposes are an entirely different matter. They may have been misguided and ineffective, but there is no evidence whatsoever that they were done for personal or corporate profit. The central bank can legitimately influence whatever market rates it needs to in pursuit of its mandate.

      You need to be extremely careful with your words. Alleging fraud, if unsupported by evidence, is defamation. I will not post any more comments on this blog that allege criminal behaviour without clear evidence.

  9. Frances says "Since the financial crisis, the excess reserves created by QE have partly emasculated the bank rate as principal policy tool..." Why can't that problem be solved by raising minimum reserve requirements? The Chinese regularly adjust reserve requirements. So presumably that ploy works.

    1. It could. But no-one seems to want to do that.

  10. I am closing comments on this post. Too many people have not bothered to read either this post or the previous one properly, and are using this as a forum to express their anger about what has happened to their trader friends. I don't think repeating what is in the post over and over again in the comments is a good use of my time. You may have axes to grind, but this is not the place to grind them.

    This remains my position.

    1. Traders and banks who manipulated Libor for personal gain deserve to feel the full force of the law, regardless of what the Bank of England and other institutions may or may not have done. "Tu quoque" is not a defence.

    2. Motives matter. If the Bank of England did influence Libor submissions, it did not do so for personal gain. It is questionable therefore whether prosecution of the Bank or its officials for fraud would succeed: even if it did, the penalties could be light or non-existent, given the lack of criminal intent. We must wait to see what the SFO says, and in the meantime, refrain from making possibly defamatory accusations.

    3. That said, lying to Parliament to conceal the Bank's involvement in Libor manipulation is unacceptable, and so is allowing others to suffer possible miscarriages of justice. In 2012 I called for a judicial inquiry into the Bank of England's role in Libor manipulation. I repeated that call in my post of two weeks ago, and I repeat it again now.

    The subject is now closed pending further developments.