BBA Announces Libor Reforms - What's the Impact?

Today, the British Bankers Association (BBA) announced two measures to strengthen Libor as well as calling for comment on several other possible changes.  Libor (the London Interbank Offered Rate) is the most widely referenced interest rate index in the world, used as the benchmark for $350 Trillion in interest rate swaps and $10 trillion in loans.

Libor originated in 1985.  It is the interest rate participant banks in the London market report that they would be charged by other banks if they sought to borrow funds on an unsecured basis.  Libor is set at 11:00 A.M. UK time in 10 currencies for 15 maturities.  The four most significant Libor currencies are: U.S. dollar, Sterling, Euro, and Yen.  Data is compiled and calculated by Reuters for BBA.  BBA's oversight committee for Libor is the Foreign Exchange and Money Market Committee; it is composed of selected participant banks.  BBA asks for volunteer banks active in the London market in the relevant currencies and in "reasonable amounts" and then establishes panels of banks for each currency, which report interest rates they "perceive" they would be charged.

The following striking facts about Libor highlight the fact that this benchmark interest rate was not originally intended -- nor is it presently constructed in a way that lends itself -- to such global importance:

• The British Bankers Association is not a government agency but an unregulated, voluntary trade association.
• Banks volunteer to join a panel of banks and voluntarily report the interest rates they would expect to pay.  Until now, reporting has been more or less on the "honor system" to report accurately.
• BBA and Libor are focused on the London market, yet this benchmark interest rate is used world-wide.  Of course, a risk premium and premiums for other factors are expected to be added on top of any benchmark rate.

Previous complaints about Libor:

• Beginning in about August 2007, as the U.S. subprime mortgage market crisis developed, concerns about the accuracy of Libor began to be expressed.  Reporting banks had an incentive to understate the interest rate they said they would be charged because if they reported a high interest rate, the market would conclude that their financial condition was distressed.
• In November 2007, the Bank of England reported that the actual cost of interbank borrowing was higher than Libor indicated.
• In March 2008, the Bank for International Settlements warned that banks could be understating their borrowing costs to appear to be in stronger financial condition.
• In April 2008, BBA announced a "fast-track" review of Libor, stating that any members deliberately misreporting interest rates would be banned.
• While European banks are concerned that Libor may be understating interest rates, some U.S. critics contend that Libor is actually too high because UK banks are risk averse and there is an inadequate supply of dollars in the London market.

Today's recommendations to strengthen Libor:

• BBA announced that it would require discrepancies between interest rates reported and those actually paid to be reviewed by the oversight committee -- and justified by the reporting bank if they were found to be inaccurate.  In my opinion, this change is long overdue.  Given the hundreds of trillions of dollars in exposure and the world wide use of this benchmark, it can no longer be an unverified number.
• BBA intends to widen membership of the Foreign Exchange and Money Market Committee and increase the size of currency panels -- including more U.S. perspective. This may or may not be necessary since Libor is clearly derived from the London market and includes global financial institutions that also have a significant U.S. presence already.  Perhaps we simply need to recognize that Libor is a London-market-based index and adjust with additional premiums as appropriate -- or choose another index.

BBA REQUESTS FOR COMMENT:

• Should there be additional dollar benchmark fixes?  In addition to the 11:00 A.M. fix of the U.S. Dollar Libor, should there be another London fix later in the day, after the U.S. financial markets have opened?  Would two fixes present insurmountable legal issues because of the vast number of existing contracts that reference the 11:00 A.M. fix?  Would two fixes create market confusion?
• Should there be an additional European dollar index to capture U.S. Dollar trading in Europe even though the majority of Euro dollar trading takes place in London?
• What about continuous, real time interest-rate reporting?
• Is it appropriate to reduce the stigma that comes from reporting high interest rates by moving to anonymous reporting?  Currently BBA reports each reporting institution and the rates it reports.  In my opinion, any move to anonymous reporting would undermine transparency, as well as accuracy -- and would be detrimental.

My suggestions for thought:

• Are these concerns about Libor limited to the current period of market instability generally?
• Now that global financial markets have become aware of the limitations inherent in relying on a London-market-based benchmark, should new benchmarks be created or selected?  Is it enough to recognize Libor for what it is and add other compensating factors or premiums?
• Where are the regulators?  I note that among the "stakeholders" BBA consulted before announcing these reforms today, we see participant and non-participant financial institutions, hedge funds, money market funds, and brokers -- but no government agencies or central banks.
• The global nature of financial markets requires that we study these Libor (or interest-rate bench mark) issues together with other key issues impacting our global financial interactions, including global capital requirements and Basel II, as well as regulatory structures such as those raised in the U.S. by the recent Paulson Report.

(ag) June 10, 2008, in Economy