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Banks May Have Manipulated Euribor Out Of Modesty

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The Libor scandal's little brother, the Euribor scandal, is different from the Libor scandal in one important way. With Libor, banks are asked where they can borrow, and so if they can borrow at 2.5% and submit 2.4% then they're lying. With Euribor, banks are asked where a prime bank can borrow, and so if they can borrow at 2.5% and submit 2.4% then ... I mean, then who knows? Maybe they're not prime? What's a prime bank? This imprecision made Euribor impossible to manipulate, for some shady tautological meaning of "impossible to manipulate," and so everyone felt very clever about avoiding scandals until they didn't.

So when Libor rates were kept artificially low in 2007-2008, as banks tried to avoid seeming weak by submitting high rates: that was fraud. But when Euribor rates were kept artificially low, that was defensible. The intuition would be "well, last year we could all borrow at 3%, this year most of us can borrow at 4%, but we don't look as prime as we used to. The best of us can still borrow at 3%, so Euribor = 3%." That's the intuition behind this amusing Banca d'Italia working paper by Marco Taboga:

Euribor rates are averages of survey responses by banks that are asked the following question: what is the interest rate that, to the best of your knowledge, a prime bank would charge another prime bank on an unsecured loan? The keyword in this question is "prime bank". Before the crisis started, the concept of prime bank was probably rather unambiguous: there were dozens of large and internationally active banks that enjoyed AAA ratings and had tiny CDS premia (around or below ten basis points); any one of these banks would be easily recognized as a prime bank. During the crisis, however, most of these banks experienced deteriorations in their credit ratings and surges in their credit spreads. Which of them are still to be considered prime? In the absence of a standard de…finition of prime bank, this is a question that calls for quite a bit of subjective judgement. Therefore, it is conceivable that after 2007 Euribor rates might have been infl‡uenced also by changes in the survey respondents’' perception of what a prime bank is. This paper provides empirical evidence in favor of this hypothesis.

The empirical evidence is more suggestive than definitive, and the effects are more visible post-2008 than during the crisis, but still. Here's the picture:

This graphs shows two methods of estimating the weight that the credit spreads of Euribor panel banks had on Euribor-OIS spreads rates: in 2007, Euribor was pretty sensitive to bank credit; in 2009/2010 it was very much not; in 2011 it slowly got more sensitive.1 You can think of sensitivity to panel-bank credit as a proxy for how many panel banks are considered prime: if you think that every bank on the panel is "prime," whatever that means, then you consider all of their borrowing costs in making your Euribor submission. If you think that only the best (and least volatile) banks are prime, then your submission becomes less sensitive to moves in credit spreads of the lesser banks.

And so, by this measure, it appears that by the end of 2008 Euribor submitters thought a lot fewer banks were prime than they did at the beginning of 2008, and that in 2011 they slowly started to get more blasé about the primeness of their peers. Or it was all fraud-driven, or this is a statistical artifact, or whatever. More suggestive than definitive.

I like the suggestion, though. The Libor scandal has always puzzled me in part because I grew up believing this:

There is a small chance that an AA-rated financial institution will default on a LIBOR loan. However, they are close to risk-free. Derivatives traders regard LIBOR rates as a better indication of the "true" risk-free rate than Treasury rates, because a number of tax and regulatory issues cause Treasury rates to be artificially low. To be consistent with the normal practice in derivative markets, the term "risk-free rate" in this book should be interpreted as the LIBOR rate.

That quote is from 2006, and looks sort of adorably naive now - banks are close to risk-free! and AA-rated for that matter! - but the guy, as the saying goes, literally wrote the book on derivatives. In financial markets, pre-crisis, Libor (and Euribor) was less "the rate at which banks borrow from each other" (or "the rate at which banks don't borrow from each other") and more "the risk-free rate for discounting stuff."2

Plenty of people - in derivative markets, but also lots of people who borrowed using Libor - thought of Libor that way: it was just "the interest rate," intended to be risk-free. Making it relatively insensitive to big-bank credit would be, on this theory, a feature, not a bug. The fact that Libor manipulation went some way toward accomplishing that is nice, in a way. But it's also fraud. You gotta submit the Libor you can borrow at, not the one you think is a good risk-free rate, because the question was "where can you borrow?" Even if you don't look so prime any more.

But Euribor manipulation? Euribor practically asks you to submit a risk-free rate. What does "prime" mean if not risk-free(-ish)?3 Euribor was manipulated for nefarious swap-profiteering reasons, it seems, as well as by accident, and that's all bad. But its definition allowed it to be manipulated for good reasons, to put less emphasis on bank borrowing costs when bank borrowing costs were unusually elevated compared to risk-free rates. So it's nice to see some evidence that banks may have done just that: "manipulated" Euribor in good ways, and without violating the letter or spirit of the Euribor rules.

What is a prime bank? A Euribor – OIS spread perspective [Banca d'Italia]

1.In this period, basically, Euribor-OIS was near zero until June '07, then did this:

2.It's pretty hard to say that now and there's been a move to OIS discounting. The quote was from the 6th edition of Hull, because it's the one on my shelf. He's apparently on 8 - anyone want to send me the current version of that quote? It's from page 76 of the 6th edition, in section 4.1 ("Types of Rates") of chapter 4 ("Interest Rates").

3.Obviously the main focus of proposed Euribor reforms is to define "prime."