Indian borrowers have grown used to meaningless benchmark rates. There has for long been a yawning gap between the prime lending rate (PLR) that banks say they will charge their best clients and the rates at which they actually lend to these same clients. The published PLR number is largely irrelevant.
A Wall Street Journal story that was published in the Thursday edition of this paper says that an even more important financial benchmark has also been misleading in recent months. That’s the London interbank offered rate, or Libor. It is perhaps the most closely tracked interest rate in the world. The banks that provide data to British Bankers’ Association on the rates at which they are borrowing money from other banks are being stingy with the truth. Why? Blame it on the credit crisis and the recent episodes of financial panic. These banks fear that if they let other banks know that they are ready to pay high rates for short-term money, there could be fears that their finances are not quite in good order, which could lead to new scares.
There are two issues here. First, if Libor is actually being understated, then this means that the actual benchmark interest rate to which trillions of dollars of borrowing is pegged should be higher than now. That’ll push up borrowing costs across the board, including for many Indian companies that have international borrowings pegged to the London benchmark. Second, the fact that banks are perhaps colluding to mislead the markets shows that reliable information on prices has the characteristics of a public good. Hence, there should be better regulatory oversight.
Libor is calculated using the results of a poll of major banks. Other benchmarks such as the yield on US treasury bills are decided by transparent market prices. Each has its own failings. But, as the Indian financial markets evolve and given the attempts to build a domestic market for corporate bonds, these are issues that our own banks and regulators will have to grapple with sooner or later.
The Libor case shows that financial market participants do tend to play a game of smoke and mirrors every now and then. That has implications for the entire economy.
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