Consumers and the Future of LIBOR – An Interview With Richard Grossman
The LIBOR rigging scandal has now pinned $455 million in fines on Barclays Bank and left a serious spot on the financial industry’s less-than-immaculate record. Manipulating LIBOR is serious business. An estimated $800 trillion in financial products are tied to LIBOR. LIBOR is a numerical estimate of a bank’s cost of borrowing (the interest that one bank charges on another when it lends money to that bank). It is calculated by anywhere from 6 – 18 banks submitting their estimates for their cost of borrowing. The top 25% and the bottom 25% of the numbers are thrown out and then the average is taken from the remaining 50%. Investment banks like Barclays care about LIBOR because its large complex derivatives and other various investment packages are pegged to it. Changing LIBOR even a little can result in millions of dollars changing hands between these banks. LIBOR also directly affects individual consumers. We spoke with Richard Grossman to learn more about the scandal. Grossman is a professor of economics at Wesleyan University, and he offered NerdWallet his take on how the LIBOR manipulation affected individuals, the bank industry as a whole, and what the future has in store for those connected with LIBOR.
How consumers got hit
Aside from huge derivatives traded between banks, small financial products held by individuals were affected. Home equity loans, adjustable rate mortgages (ARMs), credit card interest rates, and lines of credit available are often tied to LIBOR. According to Grossman, anyone with a floating rate mortgage or dependent on lines of credit was impacted by the rigging of the numbers. This is also just the direct impact, as those rates are tied to LIBOR, but there are also plenty of indirect consequences of the LIBOR rates being manipulated. “In economic terms, prices are supposed to reflect scarcity in the market,” says Grossman. “When those prices are manipulated, people aren’t paying what they should be.” So a change in the interest rates of those affected products means other valuation consequences as well.
It is true that it isn’t clear in every case that consumers paid more on their mortgages or higher interest. Since it is now evident that the manipulation has been ongoing and could have raised or lowered LIBOR on any given day, some consumers may have actually benefitted from lower rates. But, says Grossman, “there are always two sides to any trade. When someone is paying less because they’re rate was pegged to a manipulated LIBOR, the lenders, which may include individuals, are receiving less than they should be.” It isn’t clear who directly won and lost in every situation, but that isn’t the issue. When things are fair, everyone is at least on neutral ground. When things are not fair, there is always someone losing. The whole system is hurt, but it was indeed worse for individuals. “Consumers were certainly on the wrong side of many transactions,” says Grossman. “People didn’t get the right rates.”
This is the first problem, that the manipulation was unfair to consumers. The second issue is that markets in general do best when things are fair. Changing LIBOR means that everything that connects to it is suspect. Especially now that the manipulation of LIBOR is public, there is going to be some loss in confidence. According to Grossman, “people are less inclined to participate in the markets if they do not trust them. This will lead markets to shrink.” The impact of shrinking markets will be slower economic recovery ahead. “When people don’t have confidence, they won’t use financial markets. This doesn’t mean everyone is going to start putting money under their mattress, but reduced participation in markets will slow the economy.” The U.S. has already experience slowed economic growth in the second quarter, and this scandal will not do anything to help post-recession improvement.
One thing that Professor Grossman expects, for obvious reasons, is more scrutiny on the individual estimates given by banks that are used to calculate LIBOR. Until recently, these estimates were not made public, and the only number that was published was LIBOR itself, and not any of its components. Moreover, LIBOR will probably be phased out as a metric for determining rates. “I think LIBOR will eventually be superseded by something that measures actual transactions and not just individual’s estimates,” says Grossman. “Banks will probably experiment with different things to tie interest rates to before settling on one or more replacements.”
One example of a new financial metric that could become widely used is the 11th District Monthly Weighted Average Cost of Funds Index (COFI). This COFI is a calculated average that comes from data reported to the Federal Home Loan Bank of San Francisco (some adjustable rate mortgages are already tied to this index). This index measures actual lending and borrowing transactions, rather than relying on submitted estimates.
Grossman does not anticipate any additional laws or regulations put on banks, however. There is already a significant amount of regulation and oversight happening post-recession (though apparently some things do slip through the cracks). “There are already many complaints about the complexity of the Dodd-Frank legislation, so I doubt Congress or the Fed will take any official action.” He believes that pressure from the Fed (non-legal, that is) and a lack of consumer confidence will drive banks into more transparent and fair practices. “LIBOR is huge and can’t simply be replaced. I believe that an alternative measure will eventually become the dominant metric.”
The damage is done, and there likely isn’t any federal action on the way. “The takeaway in all this is that for the financial system to work, consumers have to believe in it,” says Grossman. “The U.S. economic recovery and the financial system are connected and one does well when the other does well. Keeping up consumer confidence, getting past this scandal, and making sure it doesn’t happen again are all important for our economic future.”