Morgan Stanley has called for the Bank of England to replace the British Bankers Association (BBA) in running the London Interbank Offered Rate (Libor) settings. But a less transparent rate-setting methodology is required for the move to be effective.
The BBA last month asked the UK government to consider regulating and supervising the Libor setting process following the imposition of a £290 million fine on Barclays amid allegations of rate-fixing.
Historically the benchmark-setting process has been considered a private activity run by the banking trade body, although the banks who participate in the rate-setting process are regulated by the Financial Services Authority (FSA).
Morgan Stanley research analyst, and co-author of the banks recent Interest Rate Strategy report, Elaine Lin told IFLR the BBA had not done a good job so far and therefore no longer had the market credibility to continue in their current role.
No one wants to rely on them and the valuation method they use, she said. The Bank of England or another regulator that has some resolution under the central bank or UK government would be the best alternative.
Market participants support the move. It would likely improve governance by leaving rate-setters less incentivised to manipulate the measure. Nonetheless, they argue the move will have very little impact unless different teeth are put into the system.
Certainly, Morgan Stanleys report states the transparent methodology currently used by BBA to set rates is a limitation. Every contributors rates are published individually, and the maths of arriving at the fixing is transparent, it said.
Lin agreed the UK central bank would need to modify the valuation methodology and not disclose every single detail of banks submissions to the market.
The transparent methodology currently used would have deterred banks like Barclays from making real costs of funding known to the market, she said.
Market participants also suggest amending the measure to be a post-transaction rate, rather than a forward-looking benchmark. This would remove the self-fulfilling element of the rate, said one in-house counsel at a European investment bank.
But one securitisation banker warned that if the Bank of England agreed to assume responsibility for the setting of Libor or whatever benchmark that may replace it, they would have to consider the potential unintended consequences that might arise from changing the rate setting process.
One unintended consequence might be a rate that is significantly more volatile than Libor has historically been, especially during financial crises such as the one in 2008-9, he said. If the rate continues to be based on bank funding costs, you could see market rates affecting, for example, mortgages, consumer loans and derivatives rising rapidly at just the wrong time in the business cycle.
Their comments follow remarks made by the European commissioner, Michel Barnier, this week that industry groups could no longer be trusted by themselves to set benchmark rates. And calls by the European law enforcement commissioner, Viviane Reding, for European regulators to take on a bigger role in overseeing benchmark measure, such as Libor and its European equivalent Euribor.
The European Commission also announced yesterday its plans to introduce EU-wide rules criminalising interest rate fixing.
The move, which will see manipulating benchmark rates added to insider dealing as criminal offences, aims to encourage stronger public oversight of the financial industry's role in setting these benchmarks.
Lin believed significant changes to the benchmark were unlikely in the near-term, however. There are so many legacy issues with Libor that any alternative proposed will need to be very very close to the current measure, she said. Major reform of the benchmark measure is a few years off.
Alternatives suggested to-date include allowing truly free markets to operate by, for example, conducting independent sampling of a random selection of anonymised actual trades. Lawyers in the UK have acknowledged this as a realistic alternative.
Principles underpinning Australias benchmark interest rate could also be extended to Libor to improve its transparency, integrity and avoid scope for manipulation.
When speaking with IFLR last week, 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.
Morgan Stanley believes the standard International Swap and Derivatives Association (ISDA) swap agreement will facilitate whatever Libor reforms are eventually implemented.
While we have no legal expertise whatsoever, it appears to us that the wording of the standard Isda swap agreement is surprisingly unthreatening to a change in the methodology of the Libor fixing, as it refers to a page source (in the first instance) rather than to a definition of Libor itself, the report stated.
Certainly, a change in the calculation of Libor would not be unprecedented (e.g., the change in the panel bank question in 1998), it added.
When contacted by IFLR, a Bank of England press officer said they were awaiting the conclusion of the investigation into the Libor-setting process by the UKs FSA before commenting.
An ISDA spokesperson declined to comment on the matter.