Quiz 1

Question 1

2 views on the role of financial markets and middle ground

Answer 1

1. Finance is evil. Wall st people get away with things and take advantage of poor Main Street people or don’t add value. Shuffle pieces around but don’t add value (shell game - like Wells Fargo). Experts claim to have special skills but they don’t.
2. Free markets are best for all. Markets add value by transferring risk and providing services. Prices reflect all information efficiently without any frictions or transaction costs. Any regulation of credit default swaps is counterproductive.
   Free markets are good, don’t get in the way and intervene. Regulation is counterproductive.

Middle ground: markets help in efficiently bringing borrowers and lenders together - but there are imperfections. Devil in the details. Investigate in this course.

Question 2

Clearing price

Answer 2

Is there always a clearing price?
Clearing price is the equilibrium price that people pay for a good.
Ex: water on a hot day, certain price everyone would pay.
But imagine there’s a chance that there is a poison in it. Then clearing price goes down (presumably to 0)

Question 3

Minsky Financial instability hypothesis

Answer 3

Long prosperity breeds crisis.
Relationship between financing and growth isn’t linear.
Cycle of good to bad to good
1. Starts with a conservative risk hedging
2. Then ambitious investment
3. Finally irrational exuberance and excess risk taking.
Minsky moment when the market collapses.

Improvement, confidence, prosperity, excitement, convulsion, stagnation.

Question 4

Capital markets today

Answer 4

Since 2008, financial system undergone largest financial market overhaul since Depression (late 20s, early 30s)
Market participants, regulators, and academics still learning how the dynamics of new normal work. Much thru trial and error

Some hot topics of debate:
How long can an expansion last, how is the market environment fundamentally different than free crisis, and is post-crisis regulation achieving its aims in making the system safer?

Question 5

1. How long can an expansion last?
2. How is the market environment fundamentally different than pre crisis
3. Is post crisis regulation achieving its aims in making the system safer?

Answer 5

1. Expansions don’t die of old age. Not an explicit number of years until a recession. But, old people more likely to die, so longer in expansion, more likely for a recession.
2. What are new transmission mechanisms? What will propagate shocks?
3. Or, are there newly hidden risks? Where did the risk go, and what does it look like?

Question 6

David Bowie example

Answer 6

Looking at how market innovation, issuer, investor, and policy all interact on the sides around the asset class.

Bowie wants cash now, so he sells securities backed by present and future royalty payments on pre-1990 albums.
David Pullman, wharton alumnus, makes a market innovation.
Bowie is the issuer - he does this bc he wants cash now.
Asset class: esoteric asset backed securities (ABS)
Prudential is the investor and pays $55M for 10 years.
Policy: IP or credit ratings policy could affect demand and thus price.

Market dynamics:
Bonds bought by prudential in 1997. Pre downloadable music era. Rated investment grade
Prudential sells them in 2003 and downgraded to junk bonds in 04
But paid off in full by maturity in 07

Question 7

Banks as intermediaries overview

Answer 7

People: earn income, spend on goods and services
Firms: pay employees to produce
People have different preferences. Young people and innovators like to spend more than comes in, borrowing from banks allows this. And older people like to save for later and have less of a risk appetite. Pay those with more risk to take the risk away from them

Defining features of banks are that they 1. Take deposits and 2. Make loans.
Firms interact with financial intermediation. They have corporate borrowing/saving.
And households interact w financial intermediation too and they have household borrowing and saving.
The firms and households interact as well, through household income and consumption.

Question 8

Banks as intermediaries continued

Answer 8

1. Facilitate the transfer of funds.
   From net savers (prefer liquidity) to net borrowers (longer term investments)
2. Facilitate the transfer and spreading of risk
   Diversification of idiosyncratic risk (invest in unrelated firms) and transfer from those more averse to risk to those less averse to risk.
3. Take advantage of economies of scale (buy an index)
   Reduce cost per dollar transaction. Solve a search problem.
4. Help mitigate issues of asymmetric information.
   Intermediaries are experts in their markets and so help filter info and assess risks.
   Pre and post transaction risks:
   Adverse selection: worst risks are more likely to want to transact (insurance)
   Moral hazard: engaging in risky actions after transaction

Focusing on bank lending and money supply, key to banks roles as intermediaries, in today’s lecture.

Question 9

Virtues of credit provision

Answer 9

Bank deposits in 1873 - 120M euros in London, 40M in New York, 13M in Paris, 8M in german empire.
Lot more cash outside of banks in France and Germany and non-banking countries than England, but not attainable.
Scattered more throughout the country and unable to put it together.
“Million in hands of a single banker is great power. But the same sum scattered in 10s and 50s through a whole nation is no power at all”

Question 10

Banks as intermediaries: fractional research banking

Answer 10

Banks keep a fraction of deposits in reserve and lend out the rest.
Ex: assets: 10 coins kept in reserve, 90 coins lent out. Liabilities: 100 coins deposited. Say they earn 10% on loans and pay depositors 5%

Loan ratio (L): share of deposits lent out by banks. Here, it is 0.90, since 90 of the 100 deposited coins are re-lent. Affects the broad measure of money (more availability)

Reserve ratio (R): share of deposits held in reserve (May be a requirement to hold a certain amount). Is 10/100 = .1 here

Also note: total number of coins in the system is still 100. Money base stays the same.

And banks earn spread income.
Assuming no loan default, they earn: [(.190) + (010)] - .05*100 = 4 coins
This is 10% loan earning * 90 coins lend out + 0 percent on the 10 coins kept - the 5% paying the depositors on the 100 deposited coins.

Lending amount based on lending demand rather than requirement to keep certain reserve amount.

Question 11

Money base vs broad money supply and how the different banks interact with one another.

Answer 11

Bank A starts with 1000 in deposits. Then loans out 800 and keeps 200. Bank B takes this 800 that A gives it and then has 800 in deposits. Then they loan out 640 and keep 160. Bank C then deposits the 640 and loans out 512 and keeps 128. Then Bank D deposits 512 and loans 410 and keeps 102. This continues indefinitely.
For example, a person buys a car, the car dealer deposits at bank B. And then someone buys shares at TradeWeb, then the banker deposits at bank C.

The loan ratio (L) is .8 here and reserve ratio (R) is .2

The money base (D1) is the total reserve supply in the system (also equals the initial deposit). So this is 1000 here

The broad money supply = D1 * (1+L + L squared + L cubed + …) = D1/ (1-L). And remember 1-L = R, so
Broad money supply = D1/R

Here, R is .2 and D1 is 1000, so broad money supply is 5000
This is the sum of the deposits so the total here is
4000 under loans, 1000 (money base) under reserves, and 5000 under deposits (broad money)

We do make one simplifying assumption: all funds lent out ultimately return to the banking system.

Question 12

Effects of intermediation

Suppose there is money but no lending…

Answer 12

What is relationship between broad money and the money base - they would be the same. R is 1, so they’re equal.

How is money supply increased/decreased? Change reserve ratio, bigger/smaller initial deposit.

Lloyd blankfein described himself as just a banker doing God’s work.
Employs expertise, scale, and diversification to meet demand for financial intermediation and so reduces problems of asymmetric information.

Delegation can raise agency problems. Intermediary will ultimately act in own interest. Not something that we just realized post 2008, but Thomas Jefferson in 18th century said he believes banking is more dangerous to liberties than standing armies. Doesn’t trust bankers giving money for them to use in their interests.

Question 13

Pro-cyclical nature of banking:

Hyman Minsky and macroprudential regulation

Answer 13

Minsky: expansion encourages lending and eventually reckless lending until a minsky moment occurs, which tips the economy into a recession

Macroprudential regulation aims to dampen cyclical forces. Focal point is bank safety - cut risk and leverage, increase liquidity.

Question 14

Pro-cyclical nature of banking

How does bank lending affect money supply

Answer 14

Banks lend less, money supply down. Banks lend more, money supply up

Large expansions/contractions to broad money supply occur with small changes in:
1. Money base (narrow money)
2. Banks reserve or loan ratio
This makes sense given broad money supply = Money base (D1) / reserve ratio (R)

Depositor withdrawals to hoard currency is equivalent to a base money contraction.

Question 15

US banking system in early to mid 1800s

Answer 15

• no central bank (no federal reserve)
  —> bank notes issued by private state-chartered banks made over 1500 different currencies
• relative rates: banks note discounts (% prices below face value) based on an indiviudal banks location, reputation (credit)m and the possibility the note is counterfeit
  Face value is the stated value at issuance, to be received upon maturity
  Market value is the price to buy/sell today

-overall level of borrowing/lending rates are determined by money supply and money demand
—> demand shocks include seasons, speculation, disasters, immigration
—> appetite to lend largely determines broad money supply

Crazy cyclical changes in the interest rates in the mid 1800s

Question 16

How money supply and money demand determine market rate

Answer 16

Y axis is the nominal $ loan/borrow rate
X axis is the quantity
Upward sloping money supply, downward slope money demand.
Where they intersect is the market rate.

Question 17

What happens to money supply/demand graph if the economy is booming? And then what happens as good times turn into bad times

Answer 17

If the economy is booming:
1. Banks lend out higher and higher fractions of their deposits
2. Proliferation of lending produces some poorly motivated investments
Upward sloping Money supply curve shifts to the right. Downward sloping money demand curve shifts to the right.
So, now there is a higher quantity at the EQ but it is the same market rate.

As good times turn into bad times and the minsky moment occurs:

1. Banks cut back lending due to heighten sense of default risk on loans
2. Deposits (funding sources) demand their deposits back due to heightened sense of bank default risk.
   - Banks cut back lending more bc they have fewer deposits to lend.

So, money supply shifts up and left as less money out there due to less lending. But demand stays the same. So less quantity and higher marker rate.

Question 18

Us banking panic of 1933

Answer 18

Perpetual tension aiming to dampen the pro-cyclical nature of banks. But need efficient credit intermediation

Us banking panic of 1933 - in the absence of banking service, some people reverted to barter.
“There was no money. There were no coins. We traded chickens and eggs in town for salt, sugar, baking powder, fatback”

Question 19

Early attempts to centralize the banking system

Answer 19

1694: Bank of England established
1776: revolutionary war
1781: bank of North America, philly
1787: constitution signed. Hamilton favores central bank, Jefferson opposed it
1791: first bank, 120 south third st (philly)
1792: us mint founded. First us coins produced
1816: second bank (420 chestnut st)

Central banks introduced to control loan ratios and stabilize currency’s value. But, lack of coordination with state banks - all expanding at different rates. And notes depreciated after massive loans to Congress (most lending was to the govt)

Question 20

Panic of 1907

Answer 20

Background:

• rumor of knickerbocker trust involvement in a failed cooper cornering scheme. Depositors withdrew $8M in 3 hr. By 2 pm, knickerbocker was insolvent
• Concerned with spillover, depositors withdrew money from NYC banks broadly. Hoarded cash (shoeboxes, coffee cans, mattresses)
• many banks collapsed. Loan rates rose to 70% and then to 90%. Banking system froze - no lending at any rate.

1907 panic produced political will to coordinate the monetary system

1908: congress formed a monetary commission
1910: published 15k page report of findings and recommendations
1913: federal reserve act established federal reserve system as central monetary authority. Federal reserve notes become main currency

Basic idea: manage intersection of money supply and money demand to dampen boom/bust cycles and risk of escalation. Steep learning curve.

Question 21

How central bank affects money supply

Answer 21

Same example as before with the 1000 deposits to bank A and keep 200 and lend 800
But now we add a central bank to the top, with 1000 in deposits and 1000 in reserves
The difference is that the central bank is repository for all banks reserves, and doesn’t lend them out.
The sum of the banks reserves (and cash) equal CB’s liability
So, total loans is still 4K, money base 1K, broad money 5K

Central bank can affect money supply by:

1. Changing money base
2. Changing required reserve ratio.

Question 22

Money Base: 1925-31

Answer 22

Looking at the money base on the Y axis and the time on the X axis. We see that after 1929 market crash, it plummets. Then rises again
Fatal flaw of Great Depression was that central bank initially contracted money base and then didn’t increase it quickly enough.
In the market crash, the loan ratio goes down.

Question 23

Base vs broad (1919-39j

Answer 23

Graphing money base and broad money
Broad money = base / R, so broad money higher

At 1929 market crash, base goes down big. As depression happens, base goes back up while broad money goes down. After peak unemployment they both rise and monetary and fiscal stimulus in 1934 turns things around and they both go up.

Question 24

Money base v broad money supply (1980-today)

Answer 24

They both rise from 1980 till 09 with not much abnormality. Some small spikes in money base but nothing major
Then Lehman falls’ and money base goes way up. Has been falling off slightly recently.

Question 25

Some conclusions

Answer 25

1. Bank lending creates broad money
   - but also exacerbates cyclical effects of money demand
   - extreme volatility in rates isn’t desired
2. Bank regulation tradeoff: reduce systemic risk v support growth
3. Central bank is another means of dampening money/rate volatility
   - can affect supply of money base
   - or can impose limit on loan ratio (reserve requirement) and affect formation of broad money
   - today central bank affects money demand via setting rates directly.

Question 26

Case 1: US banking panic of 1933 (just the first four pages so the focus is really about American banking industry pre this panic)

Answer 26

1933- Congress wants federal deposit insurance but FDR wants to wait
1929 banking structure - lot of debt owed to depositors. Liquid but lots of loans. State banks and national banks. National banks must be members of the Fed but states have the options. Unit banks - state bank that can’t have more than one offices. Branch banks are state banks with multiple locations
States didn’t want central bank. Civic pride for unit banks. Personal touch that they give.
Americans oppose branch banking bc don’t like concentrating financial power in large cities and scared hurt loca community development.

Banking before 1920s:
Before 1863, it’s of different types of bank notes. And discount on them based on how good they are. Note holders panicked sometimes

National Banking Act of 1863: solves bank note convertibility problem and puts 10% tax in state bank notes. Lets certain state banks issue national bank notes. Demand for government bonds helps finance civil war. Notes had uniform value throughout country
Required reserves against deposits.

Panics after 1863: a few panics, want money back

1907 panic: knickerbocker trust can’t pay back their deposits, they shut. Other banks have similar issue. J.P. Morgan rescued other institions (not knickerbocker). Ends panic as US Steel buys shades of independent steel producer from teetering brokerage house which Morgan gets pres rooseveltto approve.

Federal reserve act of 1913: creates central branch empowered to make loans to banks. Notes issued by Fed becomes principal currency. 12 fed banks throughout country to limit too much centralization

Question 27

Money market

Answer 27

Comprised of financial contracts that are less than 1 year to maturity at the time of issue
Ex: bank loans, repos, commercial paper (CPs), CDs

Maturity date = date when a contract terminates (final payment(s) made)

Interbank funding market is a key segment of the money market
Federal funds and Eurodollars are unsecured while repos are secured and backed by collateral (asset worth similar amount or more than face value of the loan)
Focus on unsecured segment of interbank market in this lecture.

Question 28

Interbank market

Answer 28

Just like households and firms borrow from banks, a bank may be motivated to borrow money from another bank to meet settlement needs (e.g. bank loans to customers)
A bank may be motivated to lend dollars to another bank to earn a higher return on excess funds
Interbank lending volume has been declining in recent years

Question 29

Interbank market transaction example:

Terms of transaction: face value (F) = 150M Loan, quoted rate (R) is 1.41% and maturity (n) is 1 day

Answer 29

Bank of NY lends 150M to first bank on Feb 3, 2020
First Bank returns the money the next day

Cost to borrow = Face value (F) * Quoted Rate (R) * maturity (n in days) / 360
So, cost to borrow here = 150M * 1.41% * 1/360 = $5875

So, first bank returns 150M + 5875 to bank of NY at maturity on the next day

Note that vast majority of interbank transactions are overnight. So agreement matures in one day (t to t+1). Transact directly or via a broker.

Question 30

Overnight interbank transaction volume (2016-today) and graph with aggregate volume and fed funds volume

Answer 30

Graph the billions of US dollars on Y axis and time on X axis and show the aggregate volume and fed funds volume lines.
Aggregate volume is Fed funds + Eurodollar and fed funds is fed funds, so the difference in the lines is the Eurodollar
We see that aggregate volume has decreased pretty sharply since 2016. The fed funds volume was 200B/day pre crisis and is now about 70B. But has remained largely the same since 2016 with some medium movement.
Fed funds graph: banks lending to one another, both sides are banks that lend to each other. Only if between federally insured banks.

Question 31

Role of central bank in interbank market

Answer 31

Federal Reserve became a clearinghouse in the interbank market
1. Holding reserve accounts at the Fed greatly facilitated funds transfers from one bank to another
—> fed funds transactions are defined by the participants both having Fed accounts.
Central bank allows for easier transactions between banks. And place to get funds if need to bc there’s a shock.

In the fed funds market, one bank lends reserves to another.
Ex: at t-1, bank A has $100 in reserves and $100 in deposits and bank B has 200 in reserves and 200 in deposits
At time t, bank A borrows 150 from bank B
So bank A t account looks like 100 in reserves + 150 in reserves as assets. And 100 in deposits and 150 as fed funds borrowed.
Bank B has 50 in reserves, 150 FF lent as assets and 200 in deposits.
The FF borrowing increases banks balance sheet size (bank A). And FF loan transforms assets (bank B). Sum of all banks reserves is unchanged.

Question 32

Second role of central bank in interbank market

Answer 32

2. Importantly, Fed acted as Lender of Last Resort (LLR), lending to banks directly (discount window loans) to absorb demand shocks.
   Households, firms interact with banks and borrow/save corporately. Additionally, banks interact with fed reserve and monetary policy with reserves and money going back and forth

In contraction, broad money may shrink due to less bank lending
Fed can offset this by crediting banks with more reserves (increase money base)

Reserve requirements:
Banks must hold a certain share of deposits in reserve. Regulatory ratio is about 10%. Deemed lowest prudent level and hasn’t changed since 1990s
Note that reserve requirement going up can force L to go down, but you can’t force more loaning (I.e. can’t force L to go up)

Seen in last lecture w money base v broad money supply graph. After Lehman falls, money base shocks upwards. Banks like to lend more bc can earn more on these loans but if loan too much, then not enough reserves on hand.

Also, US agencies and US branches of foreign banks also hold Fed accounts. Recently, US agencies have become the large lenders in FF market and US branches of foreign banks are among the largest borrowers in the FF market.

Question 33

Monetary policy tools by central bank

Answer 33

1. Set rate at which banks borrow
2. Require banks to hold ratio of deposits in reserve. Hasn’t been as big a deal recently as banks lending out less than this reserve requirement.
3. Buy/sell assets to change the quantity of reserves

Monetary policy implementation has changed over time. At present, setting rates AND buying/selling assets.

Question 34

Macro-prudential regulation

Answer 34

Post crisis, aim to improve bank sector’s ability to absorb shocks in periods of stress.
Liquidity Coverage Ratio (LCR) phased in from 2015 to 2019
Addresses banks ability to meet redemptions. Banks must keep more than 100% of 30-day stress test fund outflows in high quality liquid assets (HQLA)

LCR = HQLA/30 day net cash outflows > 100%

HQLA on the assets side with reserves and government debt securities. 30 day outflows on the liabilities side with deposits.

This encourages banks o hold reserves (not reserve req per se, but means to reduce cost of macro-prudential balance sheet regulatory requirements)
This discouraged banks from funding at a short horizon
Today, HQLA is 20 percent of banks total assets on average.

Bank regulation is monetary policy, build by the fed but lot of interplay between banks and non bank financial institutions.

Question 35

Recent FF rate volatility

Answer 35

Fed funds rate is the average market rate transaction between 2 reserve banks. Not necessarily the policy rate the fed sets but rather the rate that is used.
Step function going up from 2018 to July 2019. Then goes down. Then spike up in sept 2019 and then way down
Sept 2019 was the start of a new regime in monetary policy implementation. No real reason why this happened

Question 36

Eurodollar market

Answer 36

Euro prefix has no relation to the euro area, but rather refers to being offshore. Not EU or euro like the currency.

About 3/4 Eurocurrency deposits are Eurodollars

Eurodollars are unsecured $-denominated deposits of non-US domiciled bank (I.e. foreign bank)
Historically, mostly in London. Now, other offshore money centers like Cayman.
Not subject to US regulation. Contract written under British law
Developed in 1950s, popularity quickly ballooned (size estimated above $5T outstanding)

To be precise, offshore includes US banks “International banking facilities”
US banks include international banks “US branches”
Nonetheless, “dollar deposit” jurisdiction doesn’t necessarily coincide with other bank regulatory jurisdiction.

Eurodollars are outside the system which is why not fed funds transaction

Question 37

Small regulatory differences drive flows

Answer 37

1950s: non US residents avoid risk of $ deposit confiscation. Post WWII Soviet deposits. $ loans and $ deposits in Europe but not cross ocean
1980s: US residents avoid Ref Q = date ceiling on US bank deposits. Earn higher return on offshore deposits. $ deposits from US to Europe and $ loans from Europe to US

Today: non us banks, subject to less strict post crisis leverage regulation. Accept $ deposits from US MMMFs. US has very strict regulations post crisis.
$deposifs from US to Europe.
Foreign headquarter Eurodollar deposit originating in US. 5% in 2012, 60% in 2018

Question 38

1st and 99th percentiles of overnight bank funding rate vs federal funds rate since 2018

Answer 38

Overnight bank funding rate (OBFR)
OBFR = FF + ED, published by the Fed since 2016
Range of fed funds rates alone is narrower than range including Eurodollars
Volatility in September 2019 that nobody knows why. Spikes up with both EFFR and OBFR.
The OBFR generally is more volatile, especially the 1st perncetile (small amnt). Everything generally moving together and not massive moments overall except sept 2019 spike.

Question 39

Eurodollar role in the $ market

Answer 39

Our same situation with bank A with 1000 in deposits and loans 800 and keeps 200 (so R is .2 and L is .8)
In between banks D and E, we had a non US bank, such as Bank of Bogota, who borrows from US bc customers want dollars, so hank goes and gets them. 1:1 effect on broad money w Eurodollar while bank in fed system is .8. Eurodollar deposits rely on the amiability of $ loans.
They deposit the same $410 that bank D had in loans. They don’t keep any in reserves. Loan the entire 410
Then bank E continues as normal. Deposits 410, keeps 20 percent and loans the other 80 percent.

Eurodollar deposits affect broad money, as the total deposit will go up by 410 (5K—> 5410) The monetary base amount doesn’t change (still 1000)

Question 40

Velocity of M1 since 1960

Answer 40

Rose a lot from 1960 to 2009. Then has fallen a lot since 09. Usually falls during recessions.
Velocity is approximation of the loan ratio. Loan out less, lower velocity, as less is out there.

Question 41

Distinguishing Eurodollars from fed funds

Answer 41

Fed funds are liabilities of US banks while Eurodollars are non US banks.
Borrowing/lending $s as Fed funds:
- ff deposit/borrowing can only be a liability of a US bank and is written under US law.
Ex: a us bank has $5 in reserves, $5 as loans as their assets. And borrows $10 of FF (liability) from another US bank.
The other bank has $5 in reserves and the $10 lent as assets and $15 as deposits (liabilities)
In order to be a fed fund transaction, must have a fed account.

Borrowing/lending $ as Eurodollars
-ED deposit/borrowing is defined as liaibility of a non us bank (or offshore branch)
- an institutions ED borrowing typically = ED lending.
Ex: non us bank A has $10 in loans as assets and $10 in liabilities as ED borrowed. This comes from a US bank who has $5 in reserves and $10 in ED lent as the assets and $15 in deposits as the liab

Only difference is the US bank w US bank has FF while non us w US has ED

Question 42

How ED and FF dates relate

Answer 42

Closely related
Say we have a non US bank and 2 US banks.
US bank B lends $10 FF to US bank A. So US bank A has $10 in FF borrowed as their liabilities
Then US bank A loans $5 in ED to the non US bank who has this $5 ED borrowed as their liabilities. $5 in loans as their assets.
This $5 ED lent - Eurodollar deposits rely on the aviability of $ credit.

Asset: receiving income on money coming in
Liability: money coming out, owe interest on it
Eurodollar rate is higher - borrows at 4% and lends at 5%
Spread income if FF rate < ED date

Question 43

Overnight $ LIBOR vs FF

Answer 43

Graph time vs percent. See that $LIBOR and FF rates are basically moving together. $LIBOR very slightly higher but very close. Note that $LIBOR is a survey measure of Eurodollar rates.

Since 2018, seeing them move together. Spike in sept 2019. Down recently. LIBOR is slightly lower.

Question 44

The birth of LIBOR

Answer 44

Minos Zombanakis (Greek banker who worked for manufacturers Hanover in London) arranged an $80M syndicated floating rate loan for the shah of Iran

• a group of reference banks within the syndicate agreed to report their funding costs shortly before a loan rollover date
• the weighted average rate was the best period’s loan price

Was like a club, where rejected if you submitted a bad rate.

Question 45

LIBOR

Answer 45

Survey of Eurocurrency rates in London
In 1986, LIBOR first calculated by British bankers association (BBA)
In dollars, yen, and pound
Rate is used to set loan rates (commercial, consumer, mortgage, student), floating leg of swaps, settlement rate for IR futures
Today is the reference rate for about $360T in derivatives contracts

Question 46

Other benchmark rates inspired by LIBOR

Answer 46

EURIBOR (euro interbank offer rate)
- survey of European banks’ euro funding rate, introduced along with the euro currency in 1999. Larger set of banks surveyed, based in euro area

OBFR (overnight bank funding rate)
- volume-weighted median of combined Eurodollar and fed funds transaction rates. Published by NY Fed since 2016

Question 47

LIBOR misreporting

Answer 47

In 2008-09, trade volume declined in unsecured funding markets across the board and rates spiked. Counterparty risk priced more heavily. LIBOR misreporting in the crisis.
LIBOR has lots of faults but hard to get people to switch, as they’re used to LIBOR and use it in different rates as a reference.

Question 48

Bifurcation in FF vs ED during crisis and ED v LIBOR too

Answer 48

Correlation between changes in Eurodollar and fed funds graphing over time. They were very close up until the crisis and then grow further apart.
And Eurodollar vs LIBOR moves crazy far apart during the crisis. negative correlation at times.

LIBOR should move with Eurodollar but doesn’t. Only difference is LIBOR is survey of big banks and Eurodollar is larger group of banks.

Question 49

Libor today

Answer 49

Change: movement and indiviudal bank data now published with 3 month lag. July 2014: moved from BBA to ICE, now CME (owner of the LIBOR)
7 maturities (overnight, 1w, 1m, 2m, 3m, 6m, 12m)
5 currencies: yen, euro, dollar, pound, CHF (only report highly traded currencies)
11-16 survey participants, representative of the market
Captures survey of banks’ borrowing rate at 11 am London time
Until 2019, at what rate could you borrow funds were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am
Now under CME: LIBOR banks use waterfall reporting methodology. Average of value-weighted transaction rates prior to 11 am. Transaction derived rate. Market and transaction derived rate estimation. Based on transaction data avaibility.

Question 50

Future of LIBOR

Answer 50

End is unavoidable, but no direct regulatory mandate to get rid of it. There are some alternatives, such as SOFR (less than 1 percent of Eurodollar volume). CME hopes to keep LIBOR. Difficulty is that LIBOR is so prevalent and so much revolving around it and written into contracts so hard to get rid of. Firms continue to write new LIBOR contracts despite risks to its existence

Derivatives have most exposure to LIBOR, then loans and securitization, and then bonds.

Question 51

Barclays LIBOR case

Answer 51

Barclays rigged LIBOR rates for 2 reasons: first to benefit its trading positions and then during the financial crisis to project an image of strength and solvency.
LIBOR is the interest rate banks charged each other for short term loans. Consumer loans, mortgages, student loans, swaps all based on LIBOR.
2 main forms od rate rigging.
1. Between 2005 and 07, indiviudal traders requesting submission of rates that would benefit their transactions rather than rates at which Barclays actually believed it could borrow money.
2. During credit crisis in 07 and 08, banks concerned about appearing strong. One indicator was if banks could lend money on favorable terms, so had incentive to underreport the rates it would have to pay if it sought loans. Barclays officials ordered subordinates to submit lower LIBOR to avoid seeming weak.