Interest rates all over the world are mostly made up.
That's the verdict of a new study by the International Organization of Securities Commissions, a copy of which was obtained by Bloomberg. It found that more than half of the benchmark lending rates in the U.S., Europe and Asia are "calculated by methodologies that were unclear, not transparent and only rarely subject to specific regulatory standards or obligations." Less than half of all benchmark lending rates, in contrast, were based on actual market transactions.
In other words, the interest rates that affect personal and business loans, and hundreds of trillions of dollars in derivatives contracts around the world, are based on either guesses or lies: Not particularly comforting.
“The risk of manipulation will be greater where participants in the process have both incentive and opportunity to submit inaccurate data or apply a methodology inaccurately,” IOSCO wrote, according to Bloomberg. “Furthermore, where judgment is required in determining the data to be submitted, the problem is particularly acute.”
English translation: When banks can just make up these benchmark numbers, they're likely to cheat. Even when they can't just totally make up the numbers, they still try to find ways to cheat.
Recently the world has been focused on the rampant manipulation of one such interest rate, the London Interbank Offered Rate, or LIBOR. Barclays Capital has already paid $460 million in fines in that scandal, and more than a dozen other banks are under investigation, including JPMorgan Chase, Bank of America and Citigroup. Meanwhile, lawsuits and potential legal costs to the banks are piling up.
LIBOR is used in all sorts of financial transactions, from setting your adjustable-rate mortgage to interest-rate swaps bought by state and local governments to hedge against a jump in borrowing costs. LIBOR is supposed to be based on what a group of banks say is their daily cost of borrowing money from other banks for short periods of time.
The trouble is, these borrowing costs are self-reported, and it is pretty easy for the reporting banks to manipulate the rates if they want to. Sure enough, they have often wanted to, either to make their borrowing costs look lower than reality, or to gain a small advantage in derivatives trades, or both.
And, as it turns out, most other benchmarks around the world have the same problem, according to the IOSCO study.
After barely caring about LIBOR manipulation for many years, regulators are now trying to figure out how to fix LIBOR and other benchmark rates. A Bloomberg poll earlier this month found that investors expect the current LIBOR system to be overhauled within the next five years.
An overhaul will be tricky. There aren't always market transactions available to set interest rates; there's almost always going to be some need for estimates and human judgment in setting these rates, which means there might always be room for error or manipulation. Some in the market argue that short-term interest rates are being manipulated by central banks anyway, so there's not much harm in banks doing the same thing. And that's not always necessarily wrong.
The problem, though, is that nobody trusts the reality of LIBOR and similar benchmarks anymore, and it is unhealthy to have an untrustworthy financial system for very long.
“The Libor scandal should not be something to be hidden under the carpet because it affects the correct functioning of financial markets and the economy as a whole,” Mario Cribari, head of asset management at Veco Invest SA in Lugano, Switzerland, told Bloomberg earlier this month.