Bank of England
Last month, a jury returned the first US convictions relating to the manipulation of the London Interbank Offered Rate (LIBOR), an international financial benchmark. British traders Anthony Allen and Anthony Conti were found guilty of fraud and conspiracy for tampering with LIBOR while working for Dutch bank Rabobank. Their verdict is the latest development in a scandal that has exposed rampant fraud at some of the world’s largest banks and has revealed LIBOR’s substantial shortcomings. Recently, UK regulatory authorities have implemented measures to reform LIBOR, but these efforts may not go far enough to ensure the integrity of the rate and the assets tied to it.
The Rise of LIBOR
In the mid 1980s, growing use of futures contracts and interest rate swaps by financial firms generated demand for a reliable benchmark interest rate. The British Bankers’ Association (BBA) developed LIBOR in response. For nearly thirty years, the largest banks operating in London have submitted daily estimates for the interest rates other banks would charge them to borrow funds at different maturities. The BBA (and later the Intercontinental Exchange) averaged these submissions and published the LIBOR rates each day. Thus LIBOR essentially describes the average rate at which the world’s largest banks can borrow funds in the interbank lending market.
Following its introduction, LIBOR was quickly adopted as a benchmark interest rate for use in financial instruments and variable rate debt. Today, it is one of the most influential interest rates in the world and is referenced by over $300 trillion worth of financial assets. This is not a surprising development. Because interbank lending rates are based on the health of the world’s largest financial institutions, LIBOR essentially functions as a barometer for stability and “baseline risk” in financial markets. Payments on variable rate debt can thus be pegged to prevailing financial conditions by using LIBOR plus a spread percentage as the interest rate. However, this theory assumes that banks submit truthful and accurate estimates of their interbank borrowing costs for LIBOR calculations. The recent scandal has demonstrated that this is not always the case.
A Scandal Emerges
In mid 2008, regulators in the US and the UK began to uncover evidence that banks were manipulating LIBOR through fraudulent rate submissions. These allegations had serious implications for the world economy. If LIBOR did not accurately reflect average interbank borrowing costs, then hundreds of trillions of dollars worth of financial securities tied to LIBOR were improperly priced. Unfortunately, investigations revealed that this was in fact the case.
Barclays was the first bank to admit that it tampered with LIBOR by reporting false estimates of its interbank borrowing costs. Subsequent inquiries into other banks including RBS, UBS, and Deutsche Bank exposed similar manipulations. Worse yet, evidence has emerged that banks including JP Morgan, Citigroup, Barclays, RBS, and UBS conspired to tamper with foreign exchange markets as well as other interbank rates. Regulators have fined the offending firms and levied criminal charges against some of the traders involved. However, reforms are clearly needed to ensure that banks cannot pursue this kind of manipulation in the future.
In order to draft and implement proper reforms, regulators must ask: Why did the banks manipulate LIBOR in the first place? What motivated them to deceive investors and financial markets in this manner? Surprisingly, the answers to these questions are fairly simple. Prior to the financial crisis, LIBOR submissions were often manipulated to benefit the trading positions of the banks. These firms stood to gain or lose money depending on certain LIBOR rates, so borrowing cost estimates were frequently tailored to maximize profitability. Nonetheless, these actions had a very small effect on LIBOR and paled in comparison to the tampering that occurred during the financial crisis.
Following the collapse of Lehman Brothers in 2008, uncertainty and instability roiled financial markets. Investors began to seriously question the solvency of major financial institutions and were wary to lend to banks whose health was possibly compromised. Honest LIBOR submissions lend insight into a bank’s credit risk, so many investors began to scrutinize individual LIBOR estimates for signs of financial weakness. This provided banks with an additional incentive to manipulate their interbank rate estimates. By submitting dishonestly low rates, banks could improve investor perception of their financial health and avoid harmful withdrawals of funds and credit. Barclays manipulated its submissions in this manner, and evidence suggests that other banks did the same. Thus these institutions flagrantly misinformed investors and jeopardized the integrity of financial markets.
Attempts at Reform
In an effort to address LIBOR’s shortcomings and prevent future fraud, UK regulatory authorities have begun to draft and implement reforms to the LIBOR system. In 2012, the managing director of the Financial Services Authority, Martin Wheatley, conducted a review of LIBOR to guide this process and strengthen the reliability of LIBOR. In his report, Wheatley essentially argues that banks should still submit their own estimates of interbank borrowing costs, but that they should also be required to provide the transaction data on which these estimates are based. In addition, he contends that LIBOR should be administered not by the BBA, but by another private institution with fewer ties to the British banking industry. According to Wheatley, these reforms would restore investor confidence in LIBOR and encourage proper management of the rate in the future.
Per the Wheatley Review, the British government oversaw the transfer of LIBOR authority from the BBA to Intercontinental Exchange in February 2014. The American exchange operator has since proposed that participating banks submit relevant transaction data along with their LIBOR estimates. These reforms should improve LIBOR transparency and discourage future tampering. However, they fail to address another critical shortcoming of LIBOR: its dependence on the interbank lending market.
By definition, LIBOR is predicated on lending between large financial firms operating in London. Honest rate submissions should thus be supported primarily by data relating to interbank lending. However, transaction volume in this market is fairly low, so there are not much data on which to base these estimates. Human judgment is needed to supplement the data, and this necessarily invites subjectivity and inaccuracy. As such, LIBOR is not a completely reliable indicator of financial stability and credit risk. This is a fundamental issue with LIBOR that cannot be addressed by simple regulatory reforms.
The Case for Replacement
Considering LIBOR’s significant drawbacks, we can make a case for not simply reforming the interest rate, but replacing it with a new benchmark. An ideal overnight benchmark rate would incorporate the risk-free rate of return and a premium for average systemic default risk, reflecting the “baseline” return demanded by investors who lend to the world’s most stable financial institutions overnight. The market for interest rate swaps could be used to extrapolate a yield curve for this rate, from which longer term rates could be derived that incorporate the risk-free rate of return, the long term average default premium, a maturity premium, and inflation expectations. These rates would describe the risk of lending to the most stable financial institutions over different borrowing terms. An increase in systemic instability would prompt an increase in the average default premium, boosting the benchmark rates across the yield curve. As such, a lender could peg an interest rate on a variable rate asset to prevailing financial conditions by using the benchmark rate of the appropriate maturity as the floating component. A spread would simply be added to reflect premiums for liquidity and individual default risk, which are particular to the asset in question.
This benchmark could be constructed using large banks’ short term costs of funds. A bank acquires funds primarily from deposits, share equity, and debt issuance, and it pays a return on each of these liabilities. These returns represent the bank’s cost of acquiring funds. An overnight cost of funds rate could be calculated for the bank, and in theory this rate would incorporate the risk-free rate of return and a premium for the bank’s overnight default risk. An average of these rates from banks currently submitting LIBOR estimates would provide a nearly ideal overnight benchmark rate, and a yield curve constructed from market swap rates would provide a set of benchmark rates for various maturities.
A benchmark rate calculated from banks’ costs of funds has several advantages over LIBOR. Perhaps most significant is its complete dependency on financial figures. Banks maintain a wealth of data relating to their funding sources and costs of funds, so a benchmark rate calculated from these data would require no subjective human input. Thus the calculation would inherently deter tampering to the extent that the banks’ financial records are legitimate. In addition, banks’ costs of funds are determined entirely by market forces, not estimation by a small group of bank officials. A benchmark based on costs of funds would more accurately indicate the market’s perception of financial stability and so would be a more suitable measure of baseline asset risk. As such, this proposed benchmark would outperform LIBOR while offering security against unlawful manipulation.
Nonetheless, introducing this new rate comes with its own set of drawbacks. Replacing LIBOR would require the revision of the $300 trillion dollars’ worth of contracts that reference it. This would impose considerable costs on financial institutions and consumers. Additionally, it would be difficult to develop a standard, fair methodology for calculating firms’ costs of funds. Policymakers and economists would have to devote considerable time and energy to develop an adequate new benchmark. However, these inconveniences are relatively minor in comparison to the advantages of implementing a new benchmark rate. Financial stability and investor confidence in financial markets would certainly benefit, encouraging long run economic growth.
If nothing else, the LIBOR rigging scandal has exposed the continuing need for regulatory reform in the US and Europe. Institutional misconduct on this scale undermines investor confidence in financial markets, acting as a drag on world economies. Regulators and policymakers have a responsibility to anticipate and dismantle these barriers to growth and recovery. If they do not confront the challenge of reform, contraction may revisit the world economy sooner than they think.
Todd Lensman is a freshman in the College of Arts & Sciences at Cornell University, majoring in Mathematics and Economics.