- Special Pages
By Scott Nelson
The London interbank offered rate — which is set daily by asking banks what they would charge to lend to other banks — has formally existed since the 1970s, when the acronym Libor was first coined.
As a concept, however, it goes all the way back to 1797. It was known as “the bank rate,” and it referred to the one that the Bank of England would charge for an emergency loan. In effect, this rate became a barometer of market conditions, measuring the anxiety of borrowers and lenders alike.
The “bank rate” quickly became a trans-Atlantic benchmark, and by 1798, it was published in every major newspaper in Britain, the United States and Europe. It became the base rate for loans to farmers, homeowners and businesses around the world. The international cost of credit indirectly determined the price of flour in Baltimore and the price of slaves in New Orleans.
Setting the rate was simple during the 19th century and most of the 20th century. Britain’s biggest state-sponsored bank counted the gold in its vaults. If there was too much, the bank was sitting on unproductive gold and the rate needed to drop. If there was too little, too many ships were at sea, and the rate needed to go up. Over time, Bank of England governors discovered that the bank rate worked as an accelerator or a brake on the economy: Lower the rate to speed the economy, raise it to slow things down.
At times, the run on gold was so severe that the rate was punishingly high: 1839, 1857, 1861 and 1873, for example. Those were the dates of the worst US financial crises. Because Britain was a net lender and the US a net borrower until World War I, Britain’s bank rate mattered. Or, as Massachusetts Congressman Benjamin Gorham put it in the 1820s, “The barometer of the American money market hangs up at the Stock Exchange in London.”
When “the rate” was high, no New York merchant could borrow from another, and no farmer could get credit to plant the next year’s crops. Banks failed, mortgages were foreclosed, and grass grew on every Main Street in America. High rates usually represented some deep problem with bank assets.
Anglo-American conflict over the rate reached a peak in the 1830s with Andrew Jackson’s war against the Second Bank of the United States, something like our modern Federal Reserve. Jackson called the bank the “British bank” because of its dependence on British lenders. When the bank rate rose months before the 1832 presidential campaign, Jackson believed that it provoked a brain fever that put him in bed for a month. He told his vice president from his bed, “The Bank is trying to kill me, Mr Van Buren, but I will kill it.”
After his re-election, Jackson dealt a crippling blow to the Second Bank of the United States by withdrawing federal deposits and placing them in what his critics called his “pet banks,” whose managers tended to vote Democrat. But even Jackson’s pet banks set their interest rates using the Bank of England’s rates because Britain was still effectively America’s biggest lender.
The end of the dominance of Britain’s bank rate came with the panic of 1907. During that crisis, JP Morgan controlled the New York Clearing House, a financial institution that provided emergency liquidity to New York banks. Using the clearing House, Morgan picked winners and losers in the panic, effectively destroying banks whose management he deemed subpar. That move and the brief panic contributed to a split in the Republican Party that gave Democrats the presidency and control of Congress.
President Woodrow Wilson pushed a bill through Congress that created the Federal Reserve in 1913, freeing the US from the British “bank rate.” US international financial supremacy emerged during World War I, allowing Americans to set “the rate,” which dictated merchants’ interest rates from China to Peru. The Federal Reserve measured its own gold reserves to set rates in the same way as the Bank of England had.
After the US went off the gold standard in 1971, lenders around the world complained about the US government’s tendency to push down interest rates to keep the economy booming. Lenders demanded a proxy, a mechanism that resembled the “bank rate” that the Bank of England had set from 1797 to 1913 and the Federal Reserve had set from 1913 to 1971. This prompted the creation of Libor.
Most of the time, Libor numbers are extremely close to the Fed’s target numbers but different enough to measure one thing: banks’ fear of other banks. And Libor provided the first portent of the 2008 crisis. The numbers rose above the Fed’s target rate beginning in 2006, as large banks learned about other banks’ risky mortgage-based assets. The European Central Bank and the Fed, seeing a troubling divide between Libor and Fed rates, nonetheless calmly lowered borrowing costs and injected billions of dollars and euros.