Spreads between three-month London interbank offered rates and expected future overnight interest rates have widened again. This matters.
Rates for three-month Libor are the basis for most interest rate futures, swaps and options, and the notional outstanding of these contracts globally is in excess of $300,000bn, according to the International Swaps and Derivatives Association. Interest rates on many corporate loans, floating rate notes and residential mortgages are also tied to them.
Three-month Libor became the basis for the emerging interest rate derivatives and floating rate debt markets in the 1980s. It was seen as a reliable measure of the marginal cost of bank financing and a better anchor for the short-end of the yield curve than unpredictable policy and overnight rates.
But a lot has changed since then and for a couple of reasons three-month Libor may not now be the best measure of short-term interest rates.
First, it is no longer a good proxy for marginal bank financing costs. A Libor-contributing bank submits the rate at which it believes it could borrow funds, were it to do so by asking for and then accepting interbank offers in ‘reasonable market size’’. However, the interbank market for unsecured three-month deposits has been thin for a number of years.
Only unsophisticated banks place deposits with their competitors at maturities beyond one week. Liquidity management and credit limits deter banks from tying up their funds in this way. Rather the interbank deposit market is overwhelmingly overnight.
At longer maturities, banks borrow unsecured primarily by issuing securities to non-bank investors.
Indeed, the underlying three-month interbank market is much less important to banks’ financing costs than Libor itself because many bank assets and liabilities are indexed to three-month Libor, either directly or through hedging using interest-rate swaps.
Second, changes in the way central banks decide and implement monetary policy mean that overnight rates are now much more predictable than three-month rates. Most central banks target stable overnight rates until the next pre-determined monetary policy decision date.
For these reasons, overnight interbank rates are now a superior basis for interest-rate derivatives and floating-rate debt. Overnight interest rate fixings have the additional advantage that they are based on actual transactions rather than bankers’ quotes.
Some suspicion will always surround fixings based on quotes by banks that have a financial interest in the outcome, even if the elimination of outliers and publication of banks’ individual contributions provides some discipline. Poor liquidity in the interbank three-month deposit market has also made Libor rates inherently difficult for bank treasurers to quote.
Changing the basis for floating rate obligations from three-month Libor to overnight rates would be hugely difficult because of the massive value of outstanding transactions. But the costs of continuing to use three-month Libor are also large.
First, derivative contracts which should be a mechanism for hedging or speculating on future policy rates are contaminated by a time-varying and volatile risk premium.
Second, many banks are exposed to basis risk by the gap between three-month Libor and overnight market rates.
Third, the significance of any periodic illiquidity in the term money market for the wider economy is multiplied because it affects the floating rate that borrowers pay on their debts, exposing many people to unwanted interest rate risk and complicating monetary policy unnecessarily.
There have been some signs of investors switching to overnight interest rate derivatives: for example, turnover on futures and options on three-month eurodollar rates fell whereas turnover on those on federal funds rates rose in the fourth quarter of 2007. However, it is strange that recent events have not prompted more borrowers of floating rate money to move to an overnight basis.
The writer is chief executive of ISLA and a former head of sterling markets at the Bank of England. He is writing in a personal capacity.
