LIBOR pains : Planet Money For decades, banks used one rate to help set all other rates: LIBOR. After it came out that it'd been rigged, regulators said: no more. Now it's a race — and a road trip — to find an alternative. | Subscribe to our weekly newsletter here.

LIBOR pains

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SYLVIE DOUGLIS, BYLINE: This is PLANET MONEY from NPR.

MARY CHILDS, HOST:

One day in 2011, Dr. Richard Sandor - economist, professor - people call him Doc - Doc was in Chicago reading his newspaper, The Financial Times, and drinking his coffee when his phone rang.

RICHARD SANDOR: And I got a phone call. And somebody said, did you hear about it? Royal Bank of Scotland - they just fired four people. And I said, no, that's a game changer.

AMANDA ARONCZYK, HOST:

The somebody who called was a guy at one of the big investment banks. The gossip was that Royal Bank of Scotland appeared to be firing four traders in attempt to head off a scandal.

SANDOR: Now, when a bank does that to get ahead of the regulator, you know it's massively corrupt, right?

CHILDS: The thing that was corrupt was this thing called LIBOR. It's an acronym. It stands for the London Inter-Bank Offered Rate. LIBOR is this magic number that helps banks figure out how much to charge to lend money out. It's been called the world's most important number. And it's set by a bunch of bankers asking each other, hey, mates - oi, bruv.

ARONCZYK: Bruv?

CHILDS: Bruv. You know - oi, bruv.

ARONCZYK: (Laughter).

CHILDS: What should the number be today?

ARONCZYK: So when Doc gets that phone call, he knew it wasn't going to just be a few people at one bank.

SANDOR: And obviously, if there's one, there's got to be two. As an economist, it takes two to collude. And if there's two, there's four, right? So (laughter)...

CHILDS: What did you know in that moment?

SANDOR: That LIBOR was dead, OK? Once they fire four people, they eat - they don't eat their own unless there's some compelling reason to do it.

ARONCZYK: So Doc thinks LIBOR is doomed. It was kind of unthinkable. LIBOR underpins everything. It runs through the global economy like pipes through a city. Car loans, student loans, adjustable rate mortgages, the entire market for mega loans to giant corporations, trillions of dollars' worth - that is why it is the world's most important number because all of these loans are based on LIBOR.

CHILDS: Doc could see that we were low-key barreling towards disaster. And he's like, maybe I should do something about it, like, come up with a solution?

SANDOR: You know, I've been doing that for 50 years. I just need to study a little. And it's no different than a plumber hearing about a broken pipe.

ARONCZYK: Doc is actually a pretty credible candidate to take this on. He's known in the industry as the father of financial futures. He's been inventing financial instruments since the 1970s.

CHILDS: At the time, the banks, the borrowers - they are still all in on LIBOR. But to Doc, they're in denial. Doc - he has seen a lot of things fail over the years, and he knows that LIBOR is unfixable. So he decides to get to work.

(SOUNDBITE OF MUSIC)

CHILDS: Hello, and welcome to PLANET MONEY. I'm Mary Childs.

ARONCZYK: And I'm Amanda Aronczyk. Today on the show, the plumbing of the multitrillion-dollar global international lending system is broken. It started out shady. Then it came out that it was kind of rigged, then big scandal. Now it is ending in total chaos. Regulators have decreed that LIBOR is over.

CHILDS: And Doc, this one guy in Chicago, basically, by himself, thinks he's got a way to fix it. He's going to create his own homegrown number that he hopes will be an alternative to the world's most important number.

(SOUNDBITE OF MUSIC)

CHILDS: So what is or was LIBOR before it was enmeshed in any scandal? How did it begin? We phoned a friend.

YESHA YADAV: So I'm Yesha Yadav, and I'm from Vanderbilt Law School. I'm a professor of law.

ARONCZYK: Yesha's an expert in international banking and financial regulation. She loves thinking about where risks in our financial systems are hiding and where we should go look for them.

YADAV: Just to sort of step back a little bit, the LIBOR measure that essentially looks at how much it costs on average for a large bank to borrow funds for itself - that really was the benchmark for everything.

CHILDS: Essentially, LIBOR is how much banks would charge each other in interest for a loan. And they use that number as a standard to figure out what to charge other people for a loan.

YADAV: For a whole multi-trillion, hundreds and hundreds of trillions of dollars-worth of contracts, but more than that - for how much you would pay for your house, for your car, for how much it would cost for the milk in your fridge - LIBOR was life.

ARONCZYK: LIBOR was life. That is because the cost of lending - the cost of borrowing - is the cost of doing business. It is the cost of everything. LIBOR even has its own origin story.

YADAV: LIBOR started in 1969 or something. And it was conceived because banks were trying to price a loan to the Shah of Iran. That's the apocryphal starting point for LIBOR.

CHILDS: So the story goes the Shah needed $80 million. There's not a lot of cross-border lending going on back then, and that's a lot of money. So it wasn't like he could just call up a big bank and get his $80 million. So the Shah's, like, head of financing happens to know a Greek banker living in London. So they called that guy. And that banker called a bunch of banks. And he convinced all of them to lend the Shah the money.

ARONCZYK: So they pulled together all the money so they can get $80 million. Now, they have to figure out what the interest rate will be. But they can't all charge different rates. They're making one big deal all together, and that wouldn't make sense. So the question is, what should they agree to charge in interest? Getting that right is actually really hard. It is kind of the fundamental business of being a bank.

YADAV: Pricing a loan, getting debt right, is really, really costly. You need to work out all these different informational points to figure out exactly how much you should charge for an interest rate to a borrower. Where is the borrower living? What currency, the time - all of these different factors are really, really important in pricing a debt.

CHILDS: And the Shah's loan - this really big loan coming from all these different banks, crossing borders - it was complicated.

YADAV: So I guess the bankers figured out it would save them a lot of time and money if they took a bunch of quotes from each other as to what it would cost to borrow from one another and then use that as a basis to price the loan to the Shah of Iran.

ARONCZYK: OK, so what does that mean? Basically, the bankers decide to start with what they know. How much would it cost to lend to each other? So they call each other up, and they're like, how much would it cost you? How much would it cost you? And then they take the average of those numbers, and that average reflects the cost of lending money between these banks.

CHILDS: So they've established what they know, and now the banks have to figure out what they don't know, which is what it should cost to lend to the Shah of Iran. So, OK. They think he's going to be riskier than lending to each other. I don't know. Maybe they don't know him that well, or they've just never loaned to him before. So they're going to charge him more than what they would charge each other. The higher cost reflects that perceived higher risk.

ARONCZYK: And at that time, there's this other thing going on. Inflation is bad, and it's climbing. So these bankers - they don't want to lend out the $80 million for a fixed rate. Things are too volatile, and locking in a rate is a bad idea. So the bankers say, let's make a plan. We will keep in touch with each other. We'll check in regularly, and we will change the rate as needed. The rate will float.

CHILDS: And this worked. The loan to the Shah of Iran is said to have been the very first floating-rate loan by a group in modern finance. And it had been easy and pretty convenient to set with just a couple of phone calls.

ARONCZYK: The bankers had stumbled upon something super useful. This rate that they agreed on captured so much information so quickly and efficiently. It captured their own risk. It captured how they were all feeling that day, whether things are scary and volatile out there or placid and fine. This is the magic number. And it was so useful, everybody starts using it. It becomes super popular. They use it for all kinds of different loans. And then, in 1986, it is officially reborn.

YADAV: The British Bankers' Association took it over, and that was the start of LIBOR.

CHILDS: The real, official LIBOR - the process for finding the magic number was basically the same as the proto-LIBOR. Now, a formal panel of banks would fill out a little poll every day, asking how much they would get charged to borrow money.

ARONCZYK: LIBOR was the average. And they would throw out the top and the bottom four responses, like what they do at the Olympics, and that would protect against anyone trying to drag the rate too high or too low. And that's it. The rate is LIBOR. And remember, LIBOR is life - mortgages, student loans, dairy farms.

YADAV: So the ugly side of LIBOR is exactly as you would predict it would be, right? So what happened very early on was that banks started to misreport how much it cost to borrow funds from another bank.

ARONCZYK: The big, big banks - the Barclays, the UBS, J.P. Morgans - they are setting the rate for how much it costs to borrow and lend. And then these same big, big banks are going ahead, and they are borrowing, and they are lending based on the rates that they set. Then, they are also selling and buying sophisticated and potentially very lucrative contracts also based on the rate that they set.

YADAV: You're basically asking slightly naughty people to grade their own exam.

CHILDS: Sometimes a bank would push the number a little bit lower. And sometimes a bank would just nudge it a little bit higher, depending on how it served them that day. Changing a rate by even some tiny decimal point could be worth gabillions (ph) of dollars in profit.

ARONCZYK: And nobody really thought that much about it. LIBOR was living the good life. That is until the financial crisis of 2008.

YADAV: The way it came unraveled was that the LIBOR rate didn't seem to fit with other rates that were supposed to indicate risk in the market. So the LIBOR rate, weirdly enough, made it seem like the banks weren't that risky.

CHILDS: The banks' self-reported rate of LIBOR was indicating that things were actually really pretty good right now - thank you - no problems here - while elsewhere, other indicators looked super different - you know, the ones that were pointing towards the looming collapse of the global banking system.

ARONCZYK: Now, if you're wondering what effect this had on the interest rate on your car loan or on your mortgage or your bank loan, the answer is unclear - maybe something, but there was so much going on during the crisis, it is hard to find the signal in all of that noise. But what it showed about LIBOR is more to the point. The financial crisis revealed that something was off. Turns out, the bankers weren't just rigging their own rate. They were messaging their buddies at other banks, and they're like, can you take your rate a little higher or maybe a little lower?

YADAV: For the most part, the evidence came from chat rooms - right? - traders basically telling each other explicitly, hey, can you submit this for me for LIBOR?

CHILDS: Basically collusion.

YADAV: If you think about it, it was really super sad, right? It was really super sad that it would be so open, so brazen, so commonplace and that it would affect the lives of God knows how many millions of people that depend on LIBOR for the price of their goods and services.

CHILDS: By 2013, it was clear that LIBOR was fundamentally flawed. But it was so everywhere and in everything. So banks were still clinging to it. And regulators were trying to figure out what to do, if it could be redeemed in any way. And meanwhile, Doc, in Chicago is like, all right. This gives me time to enact my plan.

ARONCZYK: After the break, Doc - a man with a plan, a mate with a rate.

CHILDS: A duck with a rate luck.

ARONCZYK: (Laughter) A chap with a cap?

CHILDS: A dude with no collude.

ARONCZYK: (Laughter).

(SOUNDBITE OF CLIFF HAYWOOD'S "BIG APPLE BOOGALOO")

ARONCZYK: So there are trillions of dollars of loans pegged to the world's most important number. The world hasn't accepted it yet, but that number is disappearing. Meanwhile, Doc, he is busy chipping away at his idea. He's trying to establish a new number, which is still kind of a long shot because for his to be real, he needs people to believe in his number, to be like, yeah, that's the number.

SANDOR: The hard part is always convincing people that there's a major change coming. And people, by their very nature, set up economic institutions to avoid uncertainty.

CHILDS: Nobody likes uncertainty.

SANDOR: Change may have risks, but it always provides opportunities.

CHILDS: And the opportunity here, as Doc sees it, is to create something better. LIBOR was always flawed. So he's like, let's make a new thing that fixes those flaws. First up, let's maybe make it not as riggable as LIBOR. It needs to be transparent.

ARONCZYK: Doc wants to create a rate that will really reflect the actual cost of a loan between actual banks, not just what bankers say it would be hypothetically. So he needs to monitor transactions between banks.

CHILDS: And LIBOR was this big international rate set by these big international banks, which then every regional bank in America used. But why? Why isn't there a rate set by those regional banks?

ARONCZYK: So Doc wants his new rate to be primarily American. He even gives it a name that quietly suggests America. He calls it AMERIBOR.

CHILDS: AMERIBOR.

ARONCZYK: (Laughter) Anyway, Doc has his idea. He's got his name. And he has his trademark, which is a charming fedora.

CHILDS: By the way, this is something he wears all the time. When we spoke to him, he was wearing a Stetson for the warmer weather and these kind of also-trademark neon green bottle-cap glasses, like the little tiny circles, and a very fetching shirt.

SANDOR: It's blues and yellows and greens and whatnot. And it's colorful. And I'm 700 years old, so, you know, they - it's time to dress well (laughter).

CHILDS: But Doc will need more than a stunning button-down to make his idea happen. That's because small American banks weren't really lending to each other.

SANDOR: That means that even though there's banks in Wisconsin that are four-hour drives from Indiana, they don't know each other, and they don't lend and borrow from each other.

ARONCZYK: I was totally surprised to hear that, but Doc explained the smaller and regional American banks generally borrow from the big, big banks. So if Doc wants to monitor real transactions, American banks borrowing and lending to each other, he has to make those transactions happen.

CHILDS: And he has to go do it himself. He has to do this manually, sell the banks on his idea. He will have to fly or drive or train or bike or scooter or walk to banks across the country.

SANDOR: And I believe in romance and the power of America, and I do believe that nobody was going to these towns.

ARONCZYK: So this is the part of the story we should picture Doc, fancy economist from Chicago, as the main character in a road trip montage. Cue a close-up of Doc packing up his fedora, gets into his jalopy. He gathers his team. They hit the open roads to see the regional mid-sized banks of America. And he's like, hello, Little Rock.

CHILDS: Hello, Las Vegas.

SANDOR: Green Bay, Wis.

ARONCZYK: Hello, Sandwich, Ill.

CHILDS: Hello, Indianapolis.

SANDOR: Tupelo, Miss.

ARONCZYK: Hello, Butte, Mont.

SANDOR: Evansville, Ind.

CHILDS: He eats barbecue in Kansas City - that's where the best barbecue is. He visits where Elvis was born in Tupelo. He sees Indigenous art in Tulsa, and he makes his pitch. One of the first banks, First Merchants Bank, mid-sized, regional headquartered in Indiana, exactly what Doc is looking for.

ARONCZYK: There he meets the bank's CFO, Michele Kawiecki.

MICHELE KAWIECKI: We knew who Dr. Sandor was. You know, he's the father of financial future. So when we got the call, we thought, gee, what does he want to talk to us about? And he said, hey, I want to come to Indiana to see you. And we said OK.

ARONCZYK: So Doc gives them his pitch.

KAWIECKI: He walked in, and I think he had just two people with them, both really savvy about financial markets. And, you know, he had his fedora on. And he had his little specs, too. And, you know, we really didn't know what he had in mind until he came and kind of shared his idea.

CHILDS: He said, you know, LIBOR? LIBOR is going to go away, and we want to replace it. We are going to come up with our own magical number.

ARONCZYK: And Michele is watching this presentation, and she's thinking, yeah, but LIBOR is just so in everything. Like, we use it for our loans to car part manufacturers and dairy farms and construction companies.

CHILDS: Like, if you suddenly had to stop using polyester, good luck finding any clothes. It's really hard to stop. So When he's like, I'm going to create this LIBOR replacement, what do you think?

KAWIECKI: Well, I got to be honest - we were a little surprised to be a true LIBOR benchmark replacement. It just seemed like we were so far from that. And, you know, the steps that he would have to take to make that happen were kind of unclear to us at the time.

CHILDS: Right. So the first thing Doc wants to do is connect her bank in Indiana with that bank four hours away in Wisconsin and another bank in Ohio by setting up an exchange where banks can exchange money because some days, banks have too much extra money, and on other days, they need more than they have. So on whatever day that one bank needs more money, it can go to the exchange and borrow that extra money from another bank that had too much.

ARONCZYK: Now, the exchange is going to be this online platform. All of these regional banks will be there. It's like match.com but for banks who are looking for love - I mean, loans. Banks exchanging money on Doc's exchange - those are transactions, real transactions. That creates his rate. That creates AMERIBOR.

CHILDS: Michele's like, OK, LIBOR replacement. Absolutely. That sounds exciting. But that exchange - can we talk more about that one?

KAWIECKI: We were interested in the exchange, and so that's kind of where we said, yes, sign us up. We're in.

ARONCZYK: So in 2015, her bank is one of the first dozen or so banks that sign onto to Doc's exchange. For Michele, this means more people to trade with, which is great if you're a bank. Plus, once she has a relationship with these other banks, they can do - I don't know - bank-y (ph) things, bank-y business together. Meanwhile, Doc stays on the road because he needs more banks to make this exchange idea work. So he's pitching, and he's selling, and he's selling, and he's pitching.

SANDOR: I have a very simple approach to this. I have a Doberman approach. You know, you get a Doberman, and it locks on your arm. And it goes right into your muscle. So then they cut off your two front paws. And, you know, you're still locked into their arm.

CHILDS: This is very violent. I just...

SANDOR: Yes. We don't quit.

ARONCZYK: Terrifying. I'm so glad I'm not a bank in the Midwest. Anyway, he gets more and more banks to sign on. In 2015, the exchange goes live, and it keeps growing and growing. It's got over 180 regional banks signed on to borrow and lend to each other. And Michele is like, hell yeah.

KAWIECKI: Yeah. It was very validating because, you know, early on we had nothing to lose, certainly. And as it gained steam, we just felt - yeah, you felt very proud to be part of the beginning of something.

CHILDS: So you can go to, like, bank parties now, and you're like, oh, yeah, no, I was a founding member, actually.

(LAUGHTER)

CHILDS: Pretty cool. I have the mug. I have the mug to prove it.

ARONCZYK: Did they do that? Do they do the mugs and the T-shirts and the baseball caps?

KAWIECKI: They give out fedoras.

ARONCZYK: No.

CHILDS: Shut up.

KAWIECKI: Oh, yeah. You two should have fedoras. I don't - you know, when I got one, it didn't say AMERIBOR on it, but I got the fedora that's very - it's shaped just like what Dr. Sandor wears.

CHILDS: Oh, my God.

ARONCZYK: Cut to us wearing fedoras.

CHILDS: (Laughter) Amanda, no, we could not wear AMERIBOR-branded fedoras.

ARONCZYK: Look. And it's not as though I'm in the tank for AMERIBOR. I just like fedoras.

CHILDS: Well, that's fair.

ARONCZYK: Seriously, though, this is Doc's business. And he does make money off of people using his exchange.

CHILDS: At this point, it is clear that Doc was right. LIBOR was doomed. Regulators decide it cannot be fixed. It must be replaced. So for Michele, this means that every loan that had been pegged to LIBOR, the loan to the car parts manufacturer or the loan to the dairy farm - they must all be changed. And it is an absolute ton of work.

KAWIECKI: It's just, like, taking a third of your business, and you say, this is what we sell, and here's what the price is. And then you've got to say, hey, we're going to keep the price the same, but the way that we're going to explain the price has to be rewritten in thousands of documents.

ARONCZYK: I mean, what it sounds like is a huge amount of work for the bank.

KAWIECKI: It's huge. It's huge.

CHILDS: It's a lawyer employment stability act.

KAWIECKI: (Laughter) Very much so.

ARONCZYK: Next month, Michele's bank will stop using LIBOR in new contracts. That's it. No more. Her team has been thinking for a few years now about how to replace it, what to replace it with. And they basically have three options. There's Doc's rate, AMERIBOR. She likes it, thinks it's good. There's SOFR, which is the rate the Federal Reserve likes, is kind of pushing. And there's another one called BSBY by Bloomberg. And there may even be more options soon. Who knows? They all have pros and cons.

KAWIECKI: So there's these different rates that are floating around out there, and I think each bank needs to be prepared to offer the benchmark rate that their customer wants.

CHILDS: Michele and her bank will offer their customers choice. Companies borrowing from her bank will get to pick the rates that they want for the thing that they're doing. So this ice cream shop might really like the look of SOFR. And Amanda's apparently new fedora plant will actually say, you know what? I like AMERIBOR. That's the right one for me.

ARONCZYK: Now, the knock on AMERIBOR. is that it's small. It's just a few regional banks doing regional bank things, which is why Doc is still on the road. He's telling everybody about his rates, about his exchange. But also, he says he isn't actually gunning for the entire financial market.

SANDOR: I'm not interested in dominating the world interest rate benchmark. I'm interested in serving the constituents. I don't want your cake. I don't even want a slice of your cake. I just want some crumbs on the table, you know, to feed the birds (laughter).

CHILDS: Doc doesn't want to replumb the entire financial system. AMERIBOR works for loans, not for the trillions of dollars in sophisticated contracts used in international finance. He figures his new pipes could cover a small percent of what's being replaced, you know, just, like, $10 trillion worth. AMERIBOR cannot replace LIBOR completely. It is not the solution. There is no one solution.

SANDOR: We need to let people know they have choice - that they can choose their own interest rate. And why shouldn't it be like a car, like coffee? Financial services should have the same consumer sovereignty that consumer goods have.

ARONCZYK: Before everyone used LIBOR, that was just what people did. But when it came out that our one world's most important number was rigged, it was a huge deal. Now this is the year. Banks are finally phasing LIBOR out. At the end of 2021, no more new contracts pegged to LIBOR.

CHILDS: Every bank is replacing their plumbing - pipe by pipe with new and different pipes. It looks chaotic, and it's a ton of work, but maybe that LIBOR fractured into all these alternatives is fine - maybe all using one big rate was risky - maybe this way, we'll be better.

(SOUNDBITE OF MUSIC)

ARONCZYK: If you missed PLANET MONEY Summer School, it is now available in its own podcast feed - search PLANET MONEY Summer School and get all the episodes from season one and season two.

CHILDS: We love to hear from you. Email us at planetmoney@npr.org. We are also on Instagram, Twitter, Facebook and TikTok. We are @planetmoney.

ARONCZYK: Today's show was produced by Dustin Dwyer and Dave Blanchard and was mastered by Isaac Rodriguez (ph). PLANET MONEY'S supervising producer is Alex Goldmark. This episode was edited by Meg Cramer (ph). I'm Amanda Aronczyk.

CHILDS: And I'm Mary Childs. This is NPR. Thanks for listening.

(SOUNDBITE OF MUSIC)

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