LIBOR: a global credit benchmark in need of a radical overhaul

Saxon Brettell

What is LIBOR?

In the mid-1980s, borrowing by one bank from another in the un­secured inter-bank money market was a well-established way of smoothing the holding of funds while satisfying the liquidity require­ments that were intended to reduce the risk of a bank run. LIBOR (the London Inter-Bank Offered Rate) was developed as a market-based measure of international lending costs to replace the use of US Treasury Bill rates, which were perceived as too volatile and subject to distortions. LIBOR now provides a set of daily updated bench­mark interest rates that reflect the cost of inter-bank lending in ten different currencies and for different time periods. Administered by the British Bankers’ Association (BBA), it is calculated and released in London by Thomson Reuters at 11 a.m. each working day.

LIBOR is the reply to the following question to each member of a currency-specific BBA panel of 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 a.m.?”. The panels consist of between 6 and 18 major banks selected by the BBA’s Foreign Exchange and Money Markets Committee on the basis of their scale of activity in the London market, perceived expertise in the currency concerned and credit standing. Each cur­rency panel’s highest and lowest submissions are discarded, with the remaining submissions averaged to fix LIBOR for the given day.

How is it supposed to work?

LIBOR benchmark rates are intended to be objective, accurate and up-to-date measures of borrowing costs for banks in particular cur­rencies and for different terms. LIBOR spreads – across currencies and over time frames – are widely used indicators of currency ex­change risk and economic uncertainty. They are used in over $300 trillion worth of global financial contracts that underpin trade and investment.

From its inception, LIBOR developed rapidly as a reference benchmark for commercial mortgage contracts and then for deriva­tives trading, the latter rapidly overtaking LIBOR’s original role in lending markets. LIBOR benchmarked values have now become an integral reference for a huge volume of financial contracts. Small changes in the LIBOR rate can have significant consequences for the benefits and costs to counterparties in these contracts.

However, since 2009, regulators and public authorities in the USA, Canada, Japan, Switzerland and the EU have been inves­tigating alleged misconduct relating to LIBOR and other global credit cost benchmarks. Recent evidence published by US and UK regulators shows that between 2005 and 2009, LIBOR submissions by some panel member banks of the BBA were manipulated. This was to benefit their trading positions or image. The evidence is deeply damaging to the LIBOR benchmark, the reputation of inter­national investment banks and the process of regulation.

How were the ratings rigged and how was this discovered?

Evidence recently presented by the regulators in the case of Barclays (the only bank so far to admit complicity, although in August the New York attorney general reportedly subpoe­naed Deutsche Bank, Citigroup, JPMorgan Chase, Royal Bank of Scotland, HSBC and UBS in relation to LIBOR manipula­tion) has shown how some banks allowed their submissions to the BBA panels to be influenced directly by in-house traders or senior staff of the bank, causing them to alter their initial as­sessments.

A LIBOR quotation would at times be varied to influence a rate for a particular currency, so that it would directly or indirectly af­fect the overall rate. There was also informal complicity between traders in different firms to influence the LIBOR submissions of different banks. The intention was to change the targeted LIBOR rate by a few basis points so that an in-house position in a trade was more profitable.

Notably, at times of severe money market stress for the banks in 2008, quotations were apparently reduced so as to allow the bank concerned to appear to be receiving stronger market endorsement for their creditworthiness than was in fact the case. It was the last type of influencing that brought LIBOR manipulation to the attention of the US regulators in 2008 when, following the Leh­man crisis, Barclays complained that other submitters were un­derbidding on LIBOR to make their banks appear (falsely) more creditworthy than they were – something that the US Treasury brought to the Bank of England’s attention, who in turn referred the query to the BBA.

What happens to LIBOR now?

LIBOR continues as the core benchmark for international con­tracts and derivatives. Litigation over contracts affected by the LIBOR manipulation, criminal fraud investigations and fur­ther large fines from regulators for other banks involved look inevitable.

A UK Treasury review led by market conduct regulator Mar­tin Wheatley reported in September. Known as the Wheatley Review, this proposed to replace the BBA as the administrator of LIBOR with an independent private party in order to bring both the submission and administration of LIBOR into explicit regulation by the Financial Conduct Authority, and to extend proposed market abuse regulations to cover benchmark indices like LIBOR and Euribor, its European equivalent. The Review’s focus is on reform of the existing system – which remains mar­ket-led – and practical procedures to learn lessons and minimise the possibilities for future manipulation of the benchmark. It recommended the use of transaction data and other corrobora­tive approaches, but recognised that this will not be straight­forward given the low volume of inter-bank transactions in particular currencies and tenors under the current LIBOR defi­nition of inter-bank lending. For this reason, it proposed to re­duce the range of coverage of the benchmark. There was a call for improved governance and culture in banking practices to go alongside the introduction of criminal sanctions for market manipulation.

About the author:

Saxon Brettell is Director at Piametrics


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