TAILIEUCHUNG - Does the LIBOR re ect banks' borrowing costs?

Though a change in the official rate unambiguously moves other short-term rates in the same direction (even if some are slow to adjust), the impact on longer-term interest rates can go either way. This is because long-term interest rates are influenced by an average of current and expected future short-term rates, so the outcome depends upon the direction and extent of the impact of the official rate change on expectations of the future path of interest rates. A rise in the official rate could, for example, generate an expectation of lower future interest rates, in which case long rates might fall in response to an official rate rise | Does the LIBOR reflect banks borrowing costs Connan Snider UCLA Thomas Youley University of Minnesota April 2 2010 Abstract The London Interbank Offered Rate Libor is a vital benchmark interest rate to which hundreds of trillions of dollars of financial contracts are tied. Recently observers have raised concerns that the Libor may not accurately reflect average bank borrowing costs it s ostensible target. In this paper we provide two types of evidence that this is the case. We first show that bank quotes in the Libor survey are difficult to rationalize by observable cost measures including a given bank s quotes in other currency panels. Our second type of evidence is based on a simple model of bank quote choices in the Libor survey. The model predicts that if banks have incentives to affect the rate as opposed to simply reporting costs we should see bunching of quotes around particular points and no such bunching in the absence of these incentives. We show that there is strong evidence of the predicted bunching behavior in the data. Finally we present suggestive evidence that several banks have large portfolio exposures to the Libor and have recently profited from the rapid descent of the Libor. We conjecture that these exposures may be the source of misreporting incentives. Department of Economics UCLA snider@ ph 310 794-7104. Department of Economics University of Minnesota youle001@ ph 612 298-4807. 1 1 Introduction The London Interbank Offered Rate Libor is a widely used benchmark interest rate intended to reflect the average rate at which banks can borrow unsecured funds from other banks. The rate is set each day by taking a truncated average of the reported borrowing costs of a panel of 16 large banks. Since its introduction in 1986 the Libor has steadily grown in importance and is now among the most widely used benchmark rates in financial contracting. The British Bankers Association BBA estimates that 10 trillion of loans and 350 trillion

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