Does the LIBOR reflect banks’ borrowing costs?
The London Interbank Offered Rate (Libor) is a vital benchmark interest rate to which hundreds of trillions of dollars of financial contracts are tied. Recently observers have raised concerns that the Libor may not accurately reflect average bank borrowing costs, it’s ostensible target. In this paper we provide two types of evidence that this is the case. We first show that bank quotes in the Libor survey are dificult to rationalize by observable cost measures, including a given bank’s quotes in other currency panels. Our second type of evidence is based on a simple model of bank quote choices in the Libor survey. The model predicts that if banks have incentives to affect the rate (as opposed to simply reporting costs), we should see bunching of quotes around particular points and no such bunching in the absence of these incentives. We show that there is strong evidence of the predicted bunching behavior in the data. Finally, we present suggestive evidence that several banks have large portfolio exposures to the Libor and have recently proted from the rapid descent of the Libor. We conjecture that these exposures may be the source of misreporting incentives.
Full paper below…