Markets amiss and loan troubles

This will seem like an extremely minor concern for almost all of us – Dhaka’s bankers are worried about DIBOR. But it’s an interesting example of even the experts in a field not quite grasping the economic subtleties of their own business. This all becoming rather important when we try to work out how an economy should be managed or ordered. DIBOR is an attempt to create a benchmark interest rate. We can, and we do, try to roughly know the price of rice in the country, the price of petrol, we accept that it will vary a bit with quality and place and so on. A benchmark interest rate is just the same sort of idea, a guide to the price level – but here it’s the price of money. How much does it cost to borrow for some period of time? It’s a very useful thing to have but not quite in the manner that the bankers seem to think. The original of these benchmarks was LIBOR, the London Interbank Offered Rate. This has come under a certain amount of fire recently because people manipulated it in various ways. But the original idea was simple enough. There was a growing market in London for people to borrow US dollars through banks in the UK. America had some odd rules about the taxing of interest and so on so this market grew up in the American currency but outside America. Well, OK, that’s the sort of thing that happens when you’ve got odd tax rules, things move off out of the tax net. But this left the London banks with a problem. If they were to borrow in sterling, the currency of the UK, then they knew the price they could borrow money at, that was set, in the end at least, by the Bank of England. The US Federal Reserve didn’t have that same influence in London that it had in New York. So, the banks couldn’t use that American benchmark. What they did is look around and realise that they could create their own. What was the interest rate, what was the price, at which a London bank could borrow US dollars? Yes, borrow. Once you know the price you can borrow and then you know the price that you can lend at. Someone walks in and says that they’d like to borrow $1 million. So, you know what you will pay to borrow it yourself, add your costs, a bit for credit risk and there you go, you can now price your loan to the customer. The importance of LIBOR was not that a bank could lend at that price plus a bit, that was a side effect. Instead, a bank knew that it could borrow at that price, so it could always finance a loan at that plus a bit. This pleased the banks, that they could do this, and the idea spread. We’ve now LIBOR in many different currencies and in many different tenors (a tenor is a time period in this jargon, so, one day, one week, one month, one year, and this could be in yen, $, euro, and so on). Vast portions of the world’s loans are now priced at LIBOR plus a bit. Dhaka’s bankers are interested in DIBOR, but they are complaining that it doesn’t work. Unfortunately, their complaint is missing the point a bit. For they’re worrying that no one wants to borrow at DIBOR plus a bit. Further, that there is an attempt to have a one-week tenor but no one does lend for that time period, so how can there be a price? In fact, they’re missing two little bits here. The first is that, as above, the benchmark is not the rate to lend at, it’s the rate a bank can borrow at. So it’s not actually about being able to offer to clients a loan at DIBOR plus a bit. It’s much more use as a guide to the bank, that it can borrow at DIBOR and thus be sure that it can finance borrowings at that rate. The second little misunderstanding being the complaint that no one really does lend or borrow at certain tenors, further, no one is lending at any tenor in the sort of volumes which could underpin a benchmark. What’s happening is that they’re getting cart and horse the wrong way around. Sure, if there’s a big and thriving market for loans in Tk between banks, then it’s very useful to know what the price is. But it’s the existence of the big and thriving market which is the useful thing as it means that a bank can always finance, by borrowing from another bank, to fund any new loans it makes. But if DIBOR doesn’t work because there isn’t that big and liquid market then it doesn’t matter that we can’t measure the price properly, it’s the absence of the funding market which matters to the bank being able to make the loans. That is, LIBOR and DIBOR are things emergent from the market, having the benchmark is of no use without there being that market in the first place. Sure, it would be nice, it would be great even, if we had a good benchmark interest rate for lending and borrowing among banks in Tk. But it’s not the absence of the benchmark which is restricting the lending, it’s the absence of a liquid lending market which means we can’t calculate the benchmark.  Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.