The US Federal Reserve chairman yesterday branded the London Interbank
Offered Rate (Libor) setting process as structurally
flawed. But US and UK market participants have warned equivalent indices
must also be reformed if confidence in the system is to be restored.
Ben Bernanke is the latest to voice concerns over Libors widespread
inefficiencies following the $453 million penalty imposed on Barclay last month
by the US Commodity Futures and Trading Commission (CFTC) and the UKs
Financial Services Authority (FSA) amid allegations of Libor manipulation. The
fine prompted broader investigations into the Libor-setting
process within Barclays, and 16 other global financial institutions.
The key market index influences the costs of a wide range of financial
instruments. It has been estimated that $500 trillion of swaps use some form of Libor as a
reference rate. Historically, however, it has not been subject to
any direct regulation or sole supervision.
Baker & McKenzies global banking head Bernard Sharp told IFLR
that US criticism of the benchmark was likely fuelled by a long-standing
aversion to the US dollar rate being determined offshore.
Nonetheless, he agreed it was critical changes were made to the way
banks reported Libor.
Since the Lehman crisis the interbank lending market shutdown to some
extent and as such the Libor became a hypothetical, guess-based process, he
said. The market needs to admit its a guess, and base the rate-setting
process on some other factor.
Other indices, such as the Euro Interbank Offered Rate (Euribor), would
also need equivalent reforms, he said, as these operated in a similar fashion
A European investment bank securitisation head agreed. The Libor probe
raises questions about other indices, which are set on the same principles and
therefore susceptible to the same level of manipulation, such as US Libor and
Euribor, he said.
Its hard to say at this stage if its the reputation of the Libor
brand thats been damaged or just that of the bankers who are believed to have
manipulated it, he said. Regardless, changes need to be made to an index that
has become far too prone to slippage.
Most of the banking community have largely concluded the index is
rubbish because of the rate-setting process itself, he said. Traders are
generally pretty dismissive of it because its not based on actual trades and
you therefore cant put 100% confidence in the rate set.
Even so, as everybody in the market uses the same process you cant
distinguish yourself by not, as that would leave you outside the market, he
Sharp believed choosing another factor upon which to base the rate was
going to be difficult, however.
The Bank of England base measure is set for macroeconomic, political
reasons and is therefore not a true reflection of the cost of lending, Sharp
said. However a rate based on derivative prices or the cost of non-equity,
non-subordinated securities would not enable the same differentiation in
maturities as Libor offers.
Another option would be to implement provisions stipulated within the
Loan Market Association syndicated loan documentation in which it states that
if Libor does not reflect the cost of funding for a certain percentage of
banks, an alternative method of setting interest rates can be implemented based
on the banks own cost of funds. But Sharp said competition considerations
would leave most banks uncomfortable with revealing the real cost of funds. It
would also leave banks with a lot of hedging exposure, he said.
Until an alternative base rate was chosen, he believed confidence in the
system would best be restored by instigating a system whereby those giving
quotes do so without undue influence.
They should accumulate data in the same way as research analysts and
economists do in other areas of the bank, rather than operating as a trader,
When speaking with IFLR last week, CMS Cameron McKennas Daniel
Winterfeldt agreed reforms should include more
stringent internal compliance within participating banks. Efforts should
also be made to increase the number of banks contributing rates, he said.
Kelley Drye & Warrens James M Keneally said focus was also needed
on improving the audit function over Libor reporting.
This all ties back to the regulatory efforts in the US to impose on
corporations and financial institutions not just the duty to monitor themselves
but also the duty to self report, he said. An audit function with regards to
Libor makes perfect sense.
There was logic too in fine-tuning the bid process, as well as in making
bids anonymous and specifying transaction sizes, he said.
His comments mirror reforms suggested by US Treasury Secretary Timothy
Geithner, when he was head of the New York Federal Reserve Bank, in a 2008
private email to Bank of England Governor Mervyn King which emerged last week.
Some of the recommendations put forward by Geithner, in a two-page memo dated May 27 2008, include strengthening
and establishing a credible reporting procedure, increasing the size and
broadening the composition of the US dollar panel, specifying transaction size,
and eliminating incentives to misreport.
Winterfeldt believed Geithner's suggestions were generally good. But he was concerned about the second fixing option from a practical perspective. "Many transactions that use 3 month USD LIBOR have it defined in the documents as the rate set at 11am GMT, so all of these documents in the market would have to be amended to gain any benefit from a second fixing," he said.
He believed Geithner's suggestion of a random sampling of rates would be particularly effective in elminating the incentive to misreport, however.
The widespread inefficiences in the Libor-setting process has prompted some
bankers to searching for alternative benchmark rates. 81%
of IFLR readers last week voted to reform not replace Libor, however.