Should Libor be scrapped?

19th July 2012

The governor of the Bank of England, Mervyn King got the ball rolling by sending a letter Wednesday to his central bank peers requesting a meeting in September to discuss "radical reforms" to how the London interbank lending rate- the rate banks lend to each other – is set.

Indeed, just hours after the letter was sent, US Treasury Secretary Tim Geithner warned that reform of Libor will not be left "completely to the British" because their earlier efforts did not solve the problem.

"They took some modest reforms in response to our suggestions in '08, but they didn't got far enough," Mr Geithner said yesterday. "And we have now taken the initiative to set up a broader effort involving all the countries that matter around the world, that have a big stake in this, to try to make sure we push," for reforms, he said.

Geithner, however, could face "criminal liability" for failing to refer LIBOR manipulation to the Justice Department or FBI says Jim Rickards, the author of Currency Wars: The Making of the Next Global Crisis.

"A fraud is a crime. You can't witness a crime and not call the cops. Geithner might be guilty of aiding and abetting a crime."

However, when Rickards was pressed on this issue later on, he conceded that it's highly unlikely Geithner will be charged with anything – "the Justice Department will finesse it," he says.

But that won't stop members of Congress from trying to score political points and put Geithner (and Bernanke) in the hot seat in the days and weeks ahead, writes Aaron Task.

Alternatives to Libor

 So as central bankers struggle to reform the way global banks set lending rates in the wake of the Libor scandal, The Wall Street Journal's Caroline Henshaw believes that Australia's Bank Bill Swap Rate (BBSW) may provide a useful model to follow because:

"BBSW differs from Libor in three key ways. First, rates are based on actual trades rather than on self-reported estimates. Second, they are set for homogenous, prime bank-bill paper rather than lenders reporting the rates at which each individual bank estimates they can borrow. And third, other types of institutional investors in Australia-such as funds-actually take part in oversight of the market, instead of the system being run for and by the banks."

Another suggestion, according to Richard Barley, is to build on overnight index swaps, which track market expectations for central bank rates. "But OIS rates are lower than Libor, implying a subsidy to borrowers. Some suggest adjusting OIS rates to capture bank credit risk, perhaps by using credit-default swap rates. But CDS aren't necessarily liquid. Moreover, this would involve a cash rate being set via derivatives, an unsatisfactory arrangement."

"Besides, with regulators now watching Libor like hawks, the risk of abuse is probably very low. Indeed, the far bigger challenge may be to restore to health the underlying interbank lending market so that Libor can once again be based on meaningful transactions."

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