A Fraud
The exploding LIBOR scandalis already bad enough, but there are more general problems with the inter-bank offered rates.
When something like LIBOR comes up, the responses from the establishment are so predictable as to contain no information: “exceptional cases”, “bad apples”, “reestablish public confidence”, “regulator failure”, “better governance”… What if such offered rates are just badly designed, and their incentive structure is inherently flawed? What if this is not a matter of exploiting bugs but rather a matter of improper architecture?
For a long time, the rate which determined variable interest in Spain was the MIBOR, or Madrid Inter-Bank Offer Rate. Unlike its successor, EURIBOR, which we’re all fed up of hearing about given the mortgage situation, MIBOR was calculated on effectively realised operations during the previous year. The inter-bank loans were verified and aggregated by the Bank of Spain–which was the supervisory authority–and the rate was obtained from them. This system may be far from what Marxists would advocate to run a planned economy, but it was much better than what succeeded it in some very important regards.
One of the truisms of bourgeois economics–and a particular insight to the Austrian school–is that economic reality is hard to capture. It’s undeniable that in a complex economy there is a great deal of implicit–or at least yet to be made explicit–knowledge. This may manifest in many different ways: reputation knowledge about suppliers, intuition about particular market segments or consumer preferences, etc; but it is not limited to the production side. One of the stronger objections to planning lies in determining the right bundle of goods to be produced so as to maximise the utility of consumers.
Whether the notion of utility or not is best to frame this issue, it is clear that different bundles of goods have different preferences for different consumers, all else being equal. However, finding out these preferences can’t easily be done through surveys, partly because consumers don’t have very good introspection on the preference themselves. Asking consumers what goods they would like isn’t likely to yield the same results as actually seeing what happens when they are offered the goods. Hence, the notion of revealed preferences, which has been shown equivalent to utility formalisms, but somewhat operationally easier. By the logic of revealed preferences, we can’t uncover the tacit knowledge consumers have about what they like by any means other than letting them express these preferences through real transactions.
The link between revealed preferences and inter-bank offer rates arises because, unlike MIBOR, rates like EURIBOR aren’t grounded on effectively realised inter-bank operations, but merely on offers. So unlike on MIBOR, which was at least based on money which changed hands, EURIBOR rates are based on the claims banks made about the conditions on which they would hypothetically be willing to loan money to each other.
There are several reasons why this is a very bad idea:
- The operations aren’t verified by a supervisory authority, so may be entirely fictitious
- A rate based on actual operations is determined by actual objective realities, whereas one based on offers can easily be manipulated
- Even if the offer rates are issued in good faith, since they are mere hypotheticals, they will not accurately reveal the actual preferences of the agents at issue
In order to correct some of these effects, EURIBOR does have certain filters, but they’re statistically naïve and cannot entirely deal with the matter. Namely, the upper and lower 15% of offers is disregarded in reaching the rate.
Clearly, the incentive structure of such an index will lead banks to claim higher or lower offers than they would actually be willing to realise in order to move the rate itself. Further, since banks are the counterparties to the vast majority of loans, it gives one of the parties in a contract–though in an indirect and collective fashion–the power to alter the conditions of the contract unilaterally, and all under the guise of an objective and neutral rate.
Given that the vast majority of banks involved in establishing EURIBOR were involved in one way or another in the LIBOR scandal, it’s not exactly inconceivable that similar sorts of manipulations may have taken place regarding the former. In fact, anything else would be surprising. The fact EURIBOR is collated and published by a private company, under the auspices of a purportedly non-for-profit organisation, further points out the level of deregulation of the financial world, where one of the agents has completely captured the system.
If there are findings of fraud on EURIBOR, or even if it is found that the faulty method to calculate it yields non-neutral information, giving one of the contractual parties unilateral powers, the consequences could be hard to overstate for the European financial system. Borrowers would demand the return of unduly paid interest, as well as damages; foreclosed mortgages would be in question; a large number of derivatives which depend, one way or another, on such rates, would have to be looked into. Lawsuits for a decade, at least.
It’s hard to imagine the whole set of consequences from such an event. So hard to imagine that, somehow, it seems likely states would simply not allow it to occur. Whether by modifying the laws, so that such causes of action would not be possible, or in a quieter fashion, by judicial decisions which disregard such a line of argument, it seems far more likely that the system will go on as usual; at least regarding operations which already took place. However, it also seems increasingly difficult to justify such a system, and there are many calls for greater and more effective regulation of inter-bank rates, separating out the fictitious offers from the actually realised loans. We truly live in interesting times.
