The benchmark needs to be reformed, not scrapped.
Libor has come under intense scrutiny since Barclays was fined $450m in late June 2012 for manipulating it. Some of the world’s most powerful policy-makers, including Ben Bernanke, chairman of the US Federal Reserve, have attacked its flaws.
But whatever the criticisms, Libor is too important to be shelved. Its significance as a benchmark has risen since its introduction in 1986, to the point that perhaps $800tn of financial products are referenced to it. These range from interest rate swaps to corporate loans to residential mortgages.
Libor is not, as its staunchest critics point out, based on real rates. Instead, submitters give their estimates of the levels at which they could borrow from other banks. But those looking for a quick replacement based on actual trades will be disappointed. None exists that would readily suit the needs of derivatives investors and corporate borrowers that use Libor. The most commonly cited alternatives – such as repurchase agreement rates and the UK’s Sterling overnight interbank average rate – may be useful as overnight benchmarks, but beyond that tenor they are often very illiquid.
Moreover, it is arguable that Libor was never intended to be based on real borrowing rates. The fact that it is a polled estimate is part of its very attraction. Having experts that monitor the money markets every day and give their institutions’ perceived funding costs smooths out Libor in the medium term. Using traded rates would, given their illiquidity, make for a much more volatile benchmark on a day-to-day basis, which is hardly in the interests of the derivatives market.
Libor undoubtedly needs to be reformed. When the British Bankers’ Association announces its proposals later this year, some technical changes are almost inevitable. More banks might be added to the panels, while the number of tenors could be cut from 15, given that only a few – the three-, six- and 12-month ones in particular – are used extensively as benchmarks.
Most important, however, will be strengthening Libor’s governance and stipulating clear rules so that the type of manipulation going on at Barclays, and doubtless many other banks, between 2005 and 2007, when traders wanting to bolster their positions got submitters to falsify quotes, is halted. For this to work, the central banks of each of the Libor currencies might have to step in to monitor the process and punish individual bankers still intent on scamming the system.
Such measures would help Libor restore the credibility it has lost in the past two months. It would also go a long way towards bolstering financial markets. Scrapping Libor altogether would not.
