Lessons from LIBOR

In the global financial crisis, there was a moment when it looked as if major banks would collapse. There had already been the bailout of Bear Stearns, and then, moving to the UK, there was a run on Northern Rock, followed by the collapse of Lehman Brothers. Governments and regulators had to act in unison to save the whole system.

This mattered because a bank insolvency wipes out depositors and also makes debts repayable immediately. This collapses the financial system, as happened in the 1930s in America, and devastates individuals. Those with deposits may be protected to a modest level, but businesses with cash balances to pay the next day's wage bill lose the cash but still face the bill.

Individuals who have just received the money for a mortgage but have not completed the transaction lose the cash but still owe the debt, while few borrowers are able to pay back what they owe on demand. This in turn crashes asset prices as fire sales take place by both companies and individuals to try to pay back their debts to avoid insolvency.

It is against this background that the London Inter-Bank Offered Rate (LIBOR) became a focus of interest. It was one of the mainstays of the City of London's nightly clearing process. It had worked for decades, on the basis of asking the banks what rate they were offering for overnight money.

At the end of every day, all banks must balance their books. Only central banks can create money, ordinary banks must have the assets to match their liabilities. These are the opposite of an individual's, so an overdraft or mortgage is a bank asset, while a deposit is a bank liability.

Generally, there is a mismatch between the two in terms of timing, as most assets are long-term, for example, a 25-year mortgage, while the liabilities, an ordinary savings account, is repayable on demand. Nonetheless, as savers are fairly sticky, as long as the bank's own books are reasonably balanced with an excess of deposits to loans, the timing difference or duration is manageable.

This was not the case in 2008, when, for example, RBS, the parent company of NatWest, had lent out about twice as much as it had received in customer deposits. This meant that it needed to find this money in the market every day and pay out interest at the LIBOR. If it could not fund itself on a daily basis, it would have been insolvent or would have needed to call upon the Bank of England for emergency help, which would have signalled to the market its weakness, and would have led depositors to withdraw their money, exacerbating the problem both for it as a company and for the whole financial system.