How LIBOR worked in practice Now that I have described how LIBOR was intended to work in concept, how did it work in practice? It turns out that unappreciated design weaknesses and incentive structures at certain large submitting banks, in combination with the phenomenal success of reference rates, undermined the system. Conflicts and problems emerged both at the bank level and at the individual submitter level. Investigations are on-going to determine the scale and full extent of these problems, but I would like to discuss a few of the well-documented problems. Let’s start at the level of banks that submit estimates. The enforcement actions and investigations into potential LIBOR manipulation have shown that, at times, individual institutions faced incentives to understate their hypothetical borrowing rates in order to avoid the perception that they might have higher counterparty credit risk. Some of the reported misdeeds occurred during the heart of the financial crisis when market participants faced considerable uncertainty about the health of particular institutions. This uncertainty was manifest in a wide range of financial market prices for financial institutions – low and volatile equity prices, record CDS spreads and greater variation in borrowing costs across different LIBOR-submitting banks. At that time, the BBA was publishing firm-specific contributions to LIBOR from submitting banks. Given this publication process, some of the submitting banks reportedly became concerned about reporting a rate that would suggest that they were being treated by the market as a greater counterparty credit risk than their peers.
Banks have responded to the new requirements by increasing interest margins to boost earnings. It can be safely assumed that once they have adapted to the new requirements, interest margins will decrease. The countercyclical capital buffer is not an instrument for managing business cycles. The key policy rate and the buffer are designed to promote different objectives. Monetary policy is geared towards ensuring low and stable inflation and is the first line of defence for managing business cycles. The countercyclical capital buffer is designed to strengthen banks’ capacity to withstand periods of large losses. The simultaneous failure of many banks will paralyse the economy. The payments system and flow of credit for investment will seize up. The downturn could be long-lasting. This is why it is often the case that the authorities ultimately intervene in support of failing banks. This is what transpired during the Christiania crash – and it has occurred many times since then, both in Norway and other countries. It may be necessary to provide support to banks in distress, but it comes with a major drawback: Banks will expect support also in the future, which is a source of moral hazard. In spite of the term, this is not about morals, but about incentives. The banks’ creditors are induced to charge low interest rates on loans to banks. This leads to the underpricing of risk, which may in turn lead to excessive risk-taking in the banking sector. The problem must be nipped in the bud. No bank should be promised life eternal.