Is there a better way to determine Libor?

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18 July 2012

We have seen recently the resignation of Barclays chief executive, Bob Diamond, chief operating officer, Jerry del Missier and chairman, Marcus Agius, after US, Canadian and UK financial sector regulators announced that a record fine had been imposed on Barclays for inaccurately submitting Libor rates from 2005 to 2009.

The scandal looks set to continue and spread as regulators in the UK and US are investigating at least 10 other large financial institutions.  Barclays was the first of these to settle with regulators and is arguing that it was simply reacting to the game its competitors were playing.

Trillions of dollars of securities are set off the Libor rate in one form or another.  Libor forms the foundation for other interest rates and influences countless variable rate products around the world.  Does this latest scandal provide enough impetus to push through reform of Libor so that there is a better way to determine it? 

HOW IS LIBOR CURRENTLY DETERMINED?

Libor (the London inter-bank offered rate) acts as a global bench mark.  The Libor rate is needed every day for 15 different borrowing maturities in 10 different currencies.  But hard data on borrowing costs is not available every day.

The British Bankers’ Association is responsible for Libor.  They ask a group of 18 panel banks:

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” 

Thomson Reuters (on behalf of the British Bankers’ Association then takes out the top and bottom of these ‘best guess’ responses and averages the remaining data to give the rate. 

‘Best guesses’ are given by the treasury departments in panel banks.  Of course, Chinese walls are meant to be in place to prevent information flowing between the treasury estimators and panel bank dealers, whose job it is to make profit out of movements in Libor. 

ONE SCANDAL OR TWO?

Regulators allege that certain Libor panel banks made multiple attempts to depress the rate and were sometimes successful.  A look at the time period over which these attempts occurred leads to the question: is there one scandal or two?

During the 2007/2008 global financial crisis (GFC), there was an increasing feeling in the market that Libor did not truly represent the cost of funds of participating banks. It was in a bank’s interest to give the perception that it was more stable, more able to obtain a lower rate of borrowing.  In times of funding stress no one wants to stand out. 

It now seems it was clear to regulators that during the GFC Libor did not reflect the true cost of borrowing for the panel banks.  There is tacit evidence suggesting the Bank of England knew about the tinkering, as alleged by Diamond in his testimony before the British Parliament and since denied by the Bank of England’s deputy governor, Paul Tucker.  The New York Federal Reserve has now released documents showing it was aware of the Libor inaccuracies from 2007.  The documents show that in early 2008 the Federal Reserve was talking to bankers about Libor, culminating in it sending an email to the Bank of England suggesting ways to reform Libor.  The documents released also show that the governor of the Bank of England, Mervyn King, agreed with the suggestions and referred them on to the British regulators.  But none of these suggestions appear to have been followed up. 

But what about manipulation that occurred before (and after) the GFC? The email evidence released by the FSA reinforces a generalised perception by the public of bankers acting with arrogance and a disregard of ethics.  The attempts at manipulation during this period were attempts to manipulate Libor to assure that derivative bets by the banks would be profitable.  This amounts to allegations of insider trading on a large scale.  We can expect to see more investigations and actions by members of the community as a result.

Reform Libor

Why do banks still use Libor and why haven’t regulators pressed for it to be used less?  During the GFC there was some reform of the rate by adding more panel banks.  The British Bankers’ Association announced a further review earlier this year into how Libor is determined but has not set a timetable for completion of the review.  The British Parliament has announced its own inquiry into the current Libor scandal by MPs and Peers.  Investigations have also been commenced by the United States congress, the European Commission and Swiss authorities.

Libor needs to be simple, transparent and accountable.  Fundamentally, it must be based on actual interbank data and where there are gaps, these should be addressed with statistical techniques.  Information from default insurance data and credit default swaps could also be used to fill gaps. A banker’s best guess should be a last resort, not the first option.  Banks should also be required to submit information on other banks’ borrowing costs as well as their own.  This information could then be confirmed via an audit of the data.  Regulators should collect data to help find those who may attempt to manipulate the rate in the future, as it is clear that a more active role needs to be taken by regulators.

Replacement of Libor would be difficult.  Existing transactions and swaps are documented on the basis of Libor as traditionally set.  However, there is now an opportunity to consider moving to a more transparent rate and to investigate workable alternatives. 

With a continuing perception that banks were not sufficiently punished for their role in the GFC and evidence of insider trading and other scandals, governments may also take this moment to review their regulatory response to the current state of the banking sector. 




The content of this publication is for reference purposes only. It is current at the date of publication. This content does not constitute legal advice and should not be relied upon as such. Legal advice about your specific circumstances should always be obtained before taking any action based on this publication.


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Rommel Harding-Farrenberg

Partner. Sydney
+61 2 9210 6366

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