Skepticism of Experts and the End of Libor

Originally produced on Aug. 28, 2017 for Mauldin Economics, LLC

By Xander Snyder

For decades, the public generally placed its trust in technocrats, the people perceived to be skillful and knowledgeable managers of economically and politically important institutions (including banks). The thinking was that aspects of the economy and politics had become too complex for ordinary citizens to understand and that the best way to handle this complexity was to allow the experts to take over. The events of 2008-09 shattered that belief.

Its demise has swept away some of the old ways, and the next casualty is Libor, the London Interbank Offer Rate. This is the benchmark interest rate that many of the largest banks in the world charge one another for loans. It underlies an estimated $350 trillion in debt and debt-related derivatives worldwide, including everything from mortgages to corporate loans to student debt.

In July, the Financial Conduct Authority, which regulates Libor, announced that the rate would be phased out over the next four years, ending in 2021. It’s unclear what will replace it, but whatever it is won’t be as easy for bankers to manipulate.

Nearly a decade later, the 2008-09 financial crisis is still reverberating through the system, demanding the attention of regulators and affecting the global political environment. It is for this reason that the true impact of the crisis can’t be understood in purely economic terms.

Rise and Fall

The British Bankers’ Association introduced Libor in 1986 as a measure of wholesale interbank lending rates. Similar traditions existed before that point in London (where the rate originated) for syndicated loans (those that are large enough that many banks participate) whereby large banks would submit funding costs to the syndicate. Many of these banks began borrowing against this reference rate, however, which gave them incentive to underreport the cost. So the BBA began formalizing the data collection process for the interbank rate, which became Libor.

Libor is essentially set by “expert judgment.” Each day, a panel of banks submits its estimated cost of lending to another bank for various time periods to ICE Benchmark Administration (formerly the British Bankers’ Association), the administrator of the rate. What this means in practice is that only some of the bank submissions are based on real underlying transactions, and the rest are left up to traders’ estimates. In 2015, for example, about 70% of the submissions were experts’ guesses.

Two developments since the crisis of 2008-09 motivated the Financial Conduct Authority to end Libor. The first was a scandal in 2014 in which traders at several large banks were found to be conspiring to manipulate Libor rates to benefit their own trading positions… and therefore, their bonuses. The second is the decline in wholesale interbank lending in the post-crisis years. Andrew Bailey, the chief executive of the FCA, has perhaps unsurprisingly focused on the second cause in his explanation of why Libor must be abandoned.

According to the FCA, with fewer real transactions on which to base the benchmark rate, Libor becomes more and more dependent on expert guidance—that is, submissions by bank managers—which isn’t sustainable in the long run. With increased regulation following the 2014 scandal, there is a risk that banks that currently submit Libor rates will choose to leave the panel, making the benchmark rate more dependent on the estimates of fewer financial entities.

There’s some uncertainty about what will replace Libor, since several potential alternative rates have been proposed. In the United States, a panel of 15 banks voted in July to support a rate based on overnight secured lending against US Treasurys. The idea is that this new rate would be based on real transactions between banks and other private entities, not the guesswork of traders trying to bump their annual bonuses. But Libor is a rate for unsecured lending, which means that the new rate would likely be lower than Libor. For loans that are based on Libor or comparable indexes, this presents a problem for the banks: If they decide to switch to this new secured rate for existing contracts, their loans will become less profitable. This is just one possible replacement, but the inverse could also become true—costs could go up for borrowers of all types, from homeowners to students to businesses.

What’s Next?

The financial concerns about Libor are legitimate, but still, it’s unlikely that this sort of reform would have occurred were it not for the scandal and fines levied against banks. And these scandals would not have come to light were it not for the investigation into bank lending and trading practices that began after the 2008–09 financial crisis, when public confidence in the financial system evaporated.

The crisis abolished the idea that “experts” can manage the complex systems with which they have been entrusted. This is about more than the financial system. There is growing skepticism that experts of all kinds know what they’re doing. And if they don’t, will the public continue to tolerate the degree of complexity that has developed in public and financial institutions that justifies the experts’ existence?

The demise of Libor is just one example of the consequences stemming from this lack of faith. And though the FCA didn’t make its decision based on the will of the people, it’s hard to imagine that the unsustainability of this interest rate would have become as apparent as it has were it not for the investigations demanded by those who have lost confidence in the managers of the financial system.

A split has formed between people who generally trust the counsel of technocrats and those who question their intent… or at least their competency. That split is becoming increasingly visible in the West. Skepticism of experts has motivated opponents of the status quo, often materializing as nationalist parties that reject governing elites, who are unaccustomed to challenges to their authority. In Europe, this has taken the form of distrust of EU policies and national politicians who advocate them. In the US, it has pitted those with enduring confidence in elites against those suspicious of them—the divide taking the rough form (in a general sense) of the interior versus the coasts, and urban versus rural.

Divisions will only get worse as governing institutions fall victim to their own complexities and fail to provide the services their constituents want them to. There will be more financial (and other) reforms that try to respond to this growing unease. But as with most reforms, there will be winners and losers.

For now, these reforms are still being managed by those who know best how to profit from the complexity in the system. It’s unlikely that the public will be satisfied with reforms guided by technocrats in whom the public is losing confidence. Even proposed solutions that could turn out effective will be distrusted if they are introduced by what many see as a growing class that doesn’t have the public’s best interests in mind.

This is the dynamic behind popular division in Europe and the United States, and there’s no reason to believe that it will be halted within the next several years.