Are Bank ‘Errors’ Keeping Your Interest Rates DOWN?

A recent study suggests that critical interest rates may be artificially low because banks are fibbing about how high their rates might be.  In turn that interest rate is used in all kinds of financial transactions, including adjustable rate mortgages, to set the payments owed to lenders.

The Wall Street Journal has been reporting this year that market players have begun to seriously question the accuracy of the LIBOR set of interest rates.  LIBOR stands for London Interbank Offered Rate.  LIBOR is a set of interest rate averages over various short-term maturities maintained by the British Bankers Association.  It represents the interest rates 16 international banks have indicated they are or would have to pay to borrow money over the set time period (overnight up to one year) from other banks, similar to the U.S. federal funds rate. 

A bank’s reported rate is publicly disclosed.  So there has been a concern for several months that the banks would be unwilling to admit they are being charged higher rates than their competition — in effect admit that other banks consider them a greater risk — while many of them have been busy raising money.  Therefore they would have an incentive to report artificially low numbers.

The Journal commissioned a study which concluded that the LIBOR rates do appear to be artificially low.  The study uses a complex methodology but, in essence, it calculated the probable interest rates banks would have to pay based on the degree of risk the market is actually charging for providing default insurance to these banks’ lenders.  In other words, the study attempts to match up what actual traders think is the risk factor these banks represent with what the banks say they would have to pay.  The study also looked at the rates some banks were actually paying in the commercial paper market.  For example UBS was paying 2.85% per annum on 3-month commercial paper loans while reporting it could borrow from other banks at only 2.73% for the same time frame.

There are of course reasons why the LIBOR numbers could be too low.  Some are quite simple:  Many of these large banks can borrow from other sources and have done so.  In the meantime, they have not (or could not) borrow from one another.  Therefore, they would have to estimate the rates they would have to pay.  On the other hand, reporting a rate similar to the other banks also has the added benefit of not betraying any underlying weakness in a particular bank’s access to liquidity. 

And it is not necessarily sinister.  For example. the study points out Citigroup had one of the highest "spreads" between default-insurance rates and reported LIBOR rates.  Yet Citigroup’s own analysts reported in April that LIBOR appeared to be unrepresentative of actual lending rates.  And the Journal reported that, when the BBA asked Citi to withdraw the report, it refused.  If Citi is part of a conspiracy to keep LIBOR artificially low, they are very bad at it.

The Journal estimates that some $90 trillion in mortgage loans alone are tied to LIBOR rates and, if the estimates are correct, then the falsely-low LIBOR has yielded a staggering $45 billion reduction in debt payments from consumer and commercial loans tied to the rates.

Although no bank will admit they artificially deflated the rates they reported, the day the study went public LIBOR rates jumped rapidly.  The BBA, however, announced on Friday that composition of the LIBOR panel of reporting banks would not change and there would be no significant changes in the LIBOR system but possibly some more oversight.