Auction Theory and LIBOR

An article in The Economist argues that a little auction theory might solve some of the British Bankers’ Association (BBA) current LIBOR problems:

Some of LIBOR’s failures also have echoes in auctions. Traders at involved banks are accused of aligning their LIBOR estimates in an attempt to affect the final rate. They were able to cross-check what others had done, since the BBA makes individual estimates public. These traders had, in effect, formed a “bidding ring,” analogous to a sort of cartel that is familiar to observers of auctions.

Fortunately, a variety of economists have researched how to break bidding rings.  Their findings suggests that, in addition to relying on actual data (instead of estimates) and creating penalties for false bidding, the LIBOR system would benefit from a few changes focused on the weaknesses of bidding rings:

Once banks’ LIBOR bids actually have some commitment value, the system should focus on the weaknesses that auction cartels are known to have. The cartel-enforcement problem would be more acute if the BBA increased the number of submitting banks and kept those bids private. The entry of outsiders should be actively encouraged, by allowing other lenders to banks (money-market funds, say) to submit estimates, too.

Eric M. Jones.

Fair pricing of auctions is sort of key economic theory. Viz:

Nobel Prize 2002
Daniel Kahneman, Vernon L. Smith

Too bad nobody reads this stuff...

Peter Sainsbury

Given that the most credit worthy banks are already taking part isn't adding outsiders to the group of LIBOR submitters only likely to lead to higher LIBOR rates?

A P Webster

The thing is, Libor itself is increasingly irrelevant as a 'real' number - most 'inter-bank' lending dried up in 2008, and it seems at the moment that banks are happier to deposit their money with Central Banks, who then lend it out to other banks, than to take on the direct credit risk of interbank lending. Therefore, making Libor more 'honest' probably involves making it higher - with significant implications for the trillions of dollars in swap notionals, variable rate mortgages and so on.

There's also an interesting discussion on this blog, prompted by the same Economist article which is quoted above.