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Abstract
For the second time in recent months, The Wall Street Journal has run a story suggesting that members of the panel of banks whose reported borrowing costs are used to calculate a critical interest rate are under-reporting those borrowing costs, resulting in an understatement of US Libor. Libor (often termed the Libo rate in loan documents) is the most frequently used interest rate in corporate and other broadly syndicated credits. It is also used, among other things, to set interest rates on hedge instruments and many mortgages in the US. In reaching this conclusion, the Journal reviewed interest rates payable by banks under the term auction facility established by the Federal Reserve against the comparable Libo rate published by the British Bankers Association (BBA). Borrowers under the term auction facility are required to post collateral to fully secure their loans. The Libo rate, on the other hand, is meant to represent the average rate of interest at which banks lend funds to other banks on an unsecured basis. The accuracy of the BBA Libo rate depends on the accuracy of the rates submitted by panel members, and the ability of the BBA to police the accuracy of those submitted rates. While ignoring outlying high and low submitted rates helps to produce more accurate rates, it only goes so far. Critics of the system have noted that banks may have incentives to underreport the Libo rates they pay to other banks to hide their true cost of capital. Those incentives are increased during this financial crisis, when the market is closely scrutinising the financial condition and, in some cases, viability, of banks.