How to fix Libor

Author: | Published: 18 Jul 2012
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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 Libor’s widespread inefficiencies following the $453 million penalty imposed on Barclay last month by the US Commodity Futures and Trading Commission (CFTC) and the UK’s 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 & McKenzie’s 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 it’s 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 to Libor.

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.

“It’s hard to say at this stage if it’s the reputation of the Libor brand that’s 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 it’s not based on actual trades and you therefore can’t put 100% confidence in the rate set.”

Even so, as everybody in the market uses the same process you can’t distinguish yourself by not, as that would leave you outside the market, he said.

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,” said Sharp.

When speaking with IFLR last week, CMS Cameron McKenna’s 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 & Warren’s 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.