Over the past few months there has been quite a bit of debate in the world of finance over the accuracy of Libor. What is interesting about these discussions is that behind all the seemingly exact numbers lies a world of contingency, ambiguity and uncertainty where even basic notions are disputed. Maybe one day I’ll write a book on the philosophy of finance.
Libor is the London Interbank Offered Rate, the interest rate at which banks can borrow from each other in the London interbank market. It is fixed on a daily basis by the British Bankers' Association based on the rates at which a panel of 16 banks say they will lend to each other. It is calculated by leaving out the top and bottom quartile market quotes and then taking the average of the middle two quartiles. In the international money markets it functions as an important benchmark since other rates are often determined as Libor plus, say, five, ten or twenty basis points.
Since the start of the credit crisis the Fed funds rate and the 3 month eurodollar Libor rate have moved out of sync. (Eurodollars are deposits denominated in United States dollars at banks outside the United States). This means that rate cuts and other actions by central banks intended to ease the stress in the world’s financial markets had, and may continue to have, little immediate impact on interbank rates and the willingness of banks to lend to each other.
As a measure of banks willingness to lend to each other the so called TED spread is often invoked, that is the difference, between 3 month Libor and 3 month U.S. Treasury bills. It would actually be better to look at the OIS spread, that is the Overnight Index Swap spread. While you’re at it, it would be even better still to also have a look at the normalized implied volatility of the euro dollar swaption, one of the key measures of financial market uncertainty used by the Bank for International Settlements. But I won’t bother you with that.
I think it was Isaac Asimov who remarked that the most exciting phrase to hear in science, the one that heralds new discoveries, is not ‘Eureka!’ but ‘That's funny’. I think that this is what many analysts will have thought when they first noticed the widening spreads. People who, instead of looking at a Bloomberg or Reuters screen, do the calculations themselves, will most likely have checked whether there was something wrong with their calculations or have been told to do so by their bosses.
While a widening of any of these spreads is not unusual, what is unusual, is that the spread has remained high for a longer period. There were also reports in the media that banks’ actual borrowing costs may be even higher than Libor. A study by the Wall Street Journal suggested that some banks may have underreported the rate at which they could borrow. Another interpretation of these data could be a discrepancy between markets or desks within the banks.
Since the spread was real at one point some people called for a change in the calculation of Libor, which some believed to have a European bias as it involves only 3 U.S. banks, and for a U.S. alternative to Libor. The British Bankers Association resisted the calls for change and another institution initiated an alternative measure, which currently closely tracks Libor.
Why then does the spread remain so large? Why isn't it arbitraged away? At the moment it is still anybody's guess, but this article provides an interesting explanation. It may not be the full explanation, but it is an interesting theory nonetheless.
This whole process of speculation, interpretation, negotiation and data analysis, would make an fascinating case study in Actor Network Theory.
Actor Network Theory isn’t really a theory. It’s more like a practice, a way of letting the ‘actors’ speak rather than imposing a theoretical framework on them. The lesson that I took from Actor Network Theory is to try and map the entire network of actors, which can be anything from human agents to objects, that act on, contribute to, profit from etc. any given situation, process or event and to ask what the absence of or opposite of any actor would involve. That also sounds like a mouth full, but the point is that almost every day when I’m researching something I realize that my initial premises and conclusions were wrong because I hadn’t arrived at a full or at least more detailed description of what I’m researching.
In a fictional dialogue between a professor and a student on the difficulty of being an ANT Bruno Latour says more or less the same.
“If I were you, I would abstain from frameworks altogether. Just describe the state of affairs at hand.” The professor says at one point.
“‘Just describe’. Sorry to ask: but is this not terribly naïve?” The student objects. “Is this not exactly the sort of empiricism, or realism, that we have been warned against? I thought your argument was, how should I say? more sophisticated than that.”
“Because you think description is easy?” the professor then asks. “You must be confusing description, I guess, with strings of clichés. For every hundred books of commentaries, arguments, glosses, there is only one of description. To describe, to be attentive to the concrete states of affairs, to find the uniquely adequate account of a given situation, I have, myself, always found this incredibly demanding.”
A few pages later the student objects once more that he has lots of descriptions already and that what he needs is a framework to explain his descriptions, upon which the professor replies.
“I’d say that if your description needs an explanation, it’s not a good description, that’s all. Only bad descriptions need an explanation. It’s quite simple really. What is meant by an ‘explanation’, most of the time? Adding another actor to provide those already described with the energy necessary to act. But if you have to add one, then the network was not complete, and if the actors already assembled do not have enough energy to act, then they are not ‘actors’, but mere intermediaries, dopes, puppets. They do nothing, so they should not be in the description anyhow. I have never seen a good description in need, then, of an explanation. But I have read countless numbers of bad descriptions to which nothing was added by a massive addition of ‘explanations’! And ANT did not help.”
Now descriptions take time. In finance quite often there isn’t. Hence the abundance of clichés, junk explanations and references to such things as “fundamentals”, which can be either good or bad. But eventually more detailed descriptions and better explanations do emerge, because there is too much money at stake.
François-Louis Michaud and Christian Upper. What drives interbank rates? Evidence from the Libor panel. BIS Quarterly Review, March 2008.
John B. Taylor and John C. Williams, A Black Swan in the Money Market, NBER Working Paper No. 13943, April 2008.