“Why should the key interest rate index for the U.S. dollar—namely London Interbank Offered Rate (LIBOR)—be something set in London and controlled by the British Bankers Association?”
“Why isn’t this essential interest rate index for our own currency based on U.S. financial market transactions instead of a survey in some other country?”
Why indeed? These are great questions from a colleague on Capitol Hill the other day. The explanation for the LIBOR status quo seems to be a combination of historical accident and institutional inertia. But given the deep problems with LIBOR which have become so apparent, there is every reason to find a replacement for LIBOR. That the key interest rate index for our own currency should be based on U.S. markets is certainly an apt idea.
Everyone agrees it would be far better to have an index based on actual transactions in an active, arms-length financing market, where money is really changing hands, rather than the LIBOR process of a survey of opinions of a fairly small number of banks about the interest rates at which each one says it could borrow from other banks, if it were doing so.
Is there an appropriate active domestic market to use for a new index? At least one should be seriously considered for short-term rates: The discount notes of the Federal Home Loan Bank System. These notes represent a very high and homogeneous credit quality, being the joint and several obligations of the 12 Federal Home Loan Banks (FHLBanks). They are issued in frequent transactions in volumes of more than $1 trillion per year, through a large selling group of investment banks to hundreds of investors. They are linked directly to the banking system and to the housing finance system through the 8,000 financial institutions of all sizes which have ready access to short-term borrowing from the FHLBanks at rates based on the yields on FHLBanks discount notes.
The possibility of replacing LIBOR with an index of actual transactions in this transparent, active market for FHLBanks discount notes is one which should be actively studied. We will be organizing an AEI conference during the next two months to consider the idea, as well as any other possible nominations for LIBOR replacements.