Think Twice Finance

The Eurodollar Flap. The Fragility of London’s Reputation – A Financial System That Understands and Respects Market Integrity

We learned this week that the board of London bank branch officers that submit LIBOR (London Interbank Offered Rate) rates, the version of Eurodollar rates used in most contracts involving bank wholesale deposit rates, to Reuters and ultimately to the rest of the world, have been shading the rate low. Interbank deposits, to the degree they were selling at all, have been selling at about 20 basis points above the yield the banks were supplying to Reuters.

Upon learning of this, the British handled it in the typically British way. The British Bankers Association called the bankers in to discuss it with them. The BBA must have knocked these bankers upside the head or something, because in the following few days these rates received by Reuters magically rose about 20 basis points.

There are many levels upon which this tale raises curiousity. My interest is the motive for the lower rates. Telling Reuters you are paying low yields for your money does not actually make your money cheaper. That is, if the London branches of the world’s banks are actually paying 3% for their deposits, they can’t reduce their cost of funds by telling us they are paying 2.8%. Nobody thinks an auditor is that easy to fool.

On the contrary, the effect is primarily on the rates paid by borrowers on banking assets. As the world’s borrowers increasingly wised up to the fact that LIBOR was an actual market yield, while the prime rate is what bankers wished the market rate was, borrowers drove the prime ratefell into disuse and LIBOR plus some agreed spread became the yield on most banking assets. Thus by shading LIBOR down, the banks were losing profits, not gaining them.

It is argued that the issue is one of reputation, not earnings. One of the most reliable measures of what investors think of the risk of banking debt relative to the debt of others is the spread between LIBOR and the US Treasury bill rate. That might be a parochial London issue that London bankers might want to think about twice. The reputation of the London market for having the lowest wholesale yields bankers pay for dollar deposits anywhere is valuable. Indeed it has paid the huge dividend of making it the world standard, in particular the US standard, for setting loan rates. But if this reputation were to be maintained by London bankers producing fictious rates that reduce world bank earnings, that valuable franchise will surely soon go the way of the prime rate’s franchise.

London has become the world headquarters for banking transactions by using the fact that there is a community of interest between wage earners generally and financial professionals particularly due to Britain’s relatively greater share of finance in the total economy, compared to the rest of the world. Laws friendly to finance and lawmakers friendly to the competitiveness of financial financial institutions. US financial institutions have benefited as well from the pressure on financial regulations in the US resulting from competition from London, an open secret among financial professionals.

But London should beware. Protecting its image by fighting market pricing is counter to the superior understanding of the workings of the market that made London a financial center in the first place. Reputation is built in the long run, not in the short run. Britian should be careful not to sacrifice the principles upon its international respect is based to the exigencies of a faltering financial system that can be “fixed” only in the short run through expedient decisions.