GO
Loading...

How Could Libor Regain Credibility?

Thursday, 19 Jul 2012 | 1:50 AM ET

The very existence of the London Interbank Offered Rate (Libor) has been threatened by the escalating scandal involving banks allegedly manipulating the rate during the credit crisis.

Credit Crisis
CNBC.com
Credit Crisis

The credibility of the benchmark, which has been in place for nearly three decades, and affects everything from the survival of the world’s biggest banks to interest rates for ordinary savers, has been dented. Ben Bernanke, US Federal Reserve chairman, told Congress Tuesday that it is “structurally flawed.” International efforts to reform the benchmark rate are underway.

The revelations about artificial lowering of the rate, which helped mislead markets about banks’ willingness to lend to each other, have already claimed the job of ex-Barclays Chief Executive Bob Diamond. More scalps are likely to follow as the investigation continues.

So, will Libor itself be killed off? Or can it survive in a different form? (Click here for an explanation of how Libor works.)

Totally eliminating the rate, which is used to set rates for an estimated $800 trillion of derivatives and debt, sends shivers down spines in London and Wall Street.

“The size of the markets which reference Libor is so large that to abandon or radically alter it would cause unpredictable consequences,” Laurence Mutkin, European interest rate strategist at Morgan Stanley, pointed out.

A new futures contract known as the GCF (“General Collateral Financing) Repo Index Futures, launched on Monday and traded on NYSE Euronext, has been touted as a possible alternative, but pessimists believe that it is too short-term to reflect the overall tone of the market.

The British Bankers’ Association was already considering changing the way Libor was set before the scandal erupted – and this consultation has been made more urgent by recent events.

How to Fix Libor
What exactly can be done to fix the Libor system or is it worth fixing at all? Catherine Boyle has more.

At the moment, Libor is set at around 11am London time, when the banks involved in the panel which set it send the rate at which they are lending money to other banks to Thomson Reuters, via a secure network. The highest and lowest quartile rates are removed and the average of the remaining rates becomes Libor.

This basic model is followed by other inter-bank lending rate-setting panels around the world, who will doubtless be watching London closely. Several banks have quit these panels in recent days as the Libor fallout grew. Royal Bank of Scotland , for example, has left the panel which sets the Libor equivalent in Tokyo, Hong Kong and Singapore. If banks continue to drop out of setting the rate, this could itself cause its demise.

One point in Libor’s favor is that it does, with notable exceptions such as during the US sub-prime crisis, generally reflects what is in the market, as Mutkin points out. Another is that it is useful for market stability to have a benchmark rate based on three-month rather than less stable day-to-day lending.

Mutkin believes that part of the problem is that the Libor panel is just not asked the right question to reflect market realities.

“The Libor panel question as it now stands could well be re-phrased as: ‘At what rate would you do a transaction which you haven’t used much for funding during the past 20 years, and which Basel regulations discourage you from doing?’” he wrote.

The key message from London sources is that for Libor to regain credibility, it will have to become the basis for real transactions. Roughly speaking, it has to be real rather than conceptual.

One suggestion is the bank which submits the lowest rate to the panel should then be obliged to lend a set amount of money at that rate to other banks. The amount should be substantial but not enough to materially affect the bank.

The BBA could also use more up-to-date technology than the current secure network to take the Libor sample. If all Libor transactions were monitored by a single mechanism which then took an average, this argument goes, banks wouldn’t be able to fix the rates at an artificially low or high rate.

Broadening the sample beyond the 15 banks currently used to set the euro rate (the sterling panel has 16 banks and the dollar 18) is another option. Or the rate could be set by a new body rather than the BBA.

Whatever the eventual solution, the message coming from trading desks around the financial sector is that change is inevitable.

  Price   Change %Change
BARC
---
BCS'
---
RBS
---

Contact Europe: Economy

  • CNBC NEWSLETTERS

    Get the best of CNBC in your inbox

    › Learn More