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Of benchmark rates and transparency

Of benchmark rates and transparency
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First Published: Mon, May 26 2008. 12 37 AM IST

Tamal Bandyopadhyay
Tamal Bandyopadhyay
Updated: Mon, May 26 2008. 12 37 AM IST
The British Bankers’ Association, or BBA, a leading association of the UK’s banking and financial services sector representing 223 banking members from 60 countries, is meeting on 30 May to revise the ways it sets the London interbank offered rate, or Libor.
Tamal Bandyopadhyay
Central banks across the globe such as the Bank of England, the US Federal Reserve and the European Central Bank fix their official base rates at periodic intervals, but Libor reflects the actual rate at which banks borrow money from each other. It is, in fact, a barometer of how global markets are reacting to market conditions.
The rates are issued daily on more than 300,000 screens around the world and quoted as a benchmark to borrow different maturities, and a range of world currencies.
BBA uses Reuters to fix and publish the data daily, usually before 12 noon UK time. It assembles interbank borrowing rates from 16 contributor panel banks at 11am, looks at the middle eight of these rates (discarding the top and bottom four), and uses these to calculate an average, which then becomes that day’s Libor. This process is followed 150 times to create rates for 15 maturities (from overnight to 12 months), and 10 currencies.
A Bloomberg report early this month quoted Angela Knight, BBA’s chief executive officer, saying that for the first time since 1998 the association was considering changing the way it sets Libor. It is under pressure to defend Libor’s credibility after investors complained financial institutions were not telling the truth after the collapse of subprime mortgages last year.
The Bloomberg report said that while BBA set the one-month dollar Libor at 2.72% on 7 April, the US Federal Reserve said banks paid 2.82% for secured loans later that day. Secured loans typically cost less than unsecured loans, the rates of which are linked to Libor.
The report also quoted the head of asset allocation at Barclays Capital in London, the investment banking arm of Barclays Plc., saying the Libor numbers that banks reported to BBA were “a lie”. The benchmark rate jumped on 16 April after BBA warned it would ban any member found to be misquoting rates. The cost of borrowing for three months rose by 18 basis points to 2.91% the following two days, the biggest increase since August 2007 when the credit squeeze started. One basis point is one-hundredth of a percentage point.
In India, the benchmark rate for overnight money is the Mumbai interbank offer rate, or Mibor, developed by the National Stock Exchange of India Ltd, or NSE, in June 1998. The exchange has also developed benchmark rates for 14-day, one-month and three-month funds.
Mibor is now used as a benchmark rate for a majority of deals struck for interest rate swaps, forward rate agreements, floating rate debentures and term deposits, apart from overnight call money, which commercial banks lend to each other to tide over temporary asset-liability mismatches. The Fixed Income Money Market and Derivative Association of India is associated with NSE in the creation of benchmark rates.
Mibor is based on rates polled by NSE from a representative panel of 33 banks and primary dealers that buy and sell government bonds. The exchange declares every day’s benchmark rates at 9.55am for overnight money, and at 12.15pm for 14-day, one-month and three-month borrowings.
The 14-day and one-month Mibor have, however, not been used extensively. It is because the term money market has not yet developed in India. Also, on Saturday, when the money market is virtually closed and very few banks borrow or lend, it is difficult to arrive at a benchmark rate. The authorities are believed to be looking into this. Commercial banks normally borrow three-day money on Friday to meet needs. They rarely need to access the market over the weekend.
While Mibor’s acceptance as a benchmark rate for overnight money is not questioned, the benchmark rate for commercial banks’ lending—the prime lending rate, or PLR— lacks credibility. All loans given by Indian commercial banks are linked to their PLR, but nobody knows how a bank arrives at it. Theoretically, a bank needs to look at the cost of their money and top it up with a margin to create the rate.
The composition of the source of money that banks lend to corporations and individuals—the deposit base—varies from bank to bank. For instance, banks that have higher current and savings accounts in their kitty have lower cost of funds. It is because they do not pay any interest on current accounts and 3.5% interest on savings accounts, while interest rate on term deposits can vary between 6% and 12%.
Despite this, there is not much of a difference in the PLR of public sector banks, which account for close to 70% of the Indian banking industry. Also, any rate signal by the central bank normally evokes uniform response from commercial banks. It means if the Reserve Bank of India raises its policy rate, banks raise their PLR—all of them by an identical margin — and vice versa. How is this possible when the cost of funds varies from bank to bank? Apart from the herd mentality, it also shows a complete lack of transparency. It is high time the Indian Banks’ Association, BBA’s counterpart in India, started looking into it.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint.
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First Published: Mon, May 26 2008. 12 37 AM IST