Who should be in charge of setting Libor?

28th September 2012

The BBA has long been a reluctant participant in the Libor process. In this piece on the Huffington Post, Angela Knight is quoted in 2008, saying: "Longer term (she) thought it would be necessary to look at whether a trade association was best placed to continue to provide what represented a key piece of market infrastructure."

Now it says it will support any decision made by Martin Wheatley, who will publish his three-month probe into Libor on Friday: "The British Bankers' Association said it would agree with any recommendation by Martin Wheatley, the head of financial conduct at the Financial Services Authority, to hand over control of Libor to another body.

"In a statement, the BBA said it had been co-operating with Mr Wheatley's review of Libor ahead of the publication of his report on Friday. "If Mr Wheatley's recommendations include a change of responsibility for Libor, the BBA will support that," it said. The BBA has been heavily criticised for the way it has run Libor, although it has argued that it was not directly responsible for compiling the rate."

In practice, it seems likely that the BBA will be relieved of its role. But what will take its place? There are a few options under discussion. Given the recent difficult history of Libor, part of the changes will be ‘stick' rather than carrot. For example, Sky News reports that: "The managers of traders who set Libor and other benchmark interest rates will have to be formally authorised by financial regulators and subjected to tough new sanctions for malpractice, according to a Government-commissioned review of the rate-rigging scandal."

"I also understand that Mr Wheatley will outline a series of tough new sanctions for those found guilty of attempting to manipulate benchmark interest rates, and that the Libor name and framework will not be scrapped, as some had suggested."

But this doesn't necessarily get to the heart of the problem. At the moment, Libor is constructed by banks estimating what they would have to pay if they asked other banks to lend to them. This would be fine if banks were honest, but if the credit crunch has taught us anything, it is that any system relying on the integrity of bankers is flawed.

This piece in the Economist discusses an alternative: "(Wheatley) is expected to demand increased use of hard data from actual lending transactions. This would improve accuracy." This is not without repercussions, however: "LIBOR rates are needed in currencies and maturities that are not traded every day. One solution is to use extrapolation to fill in the data gaps; another is to opt for a narrower set of LIBOR rates."

Any change to the Libor rates could have an impact on derivatives contracts: "Major changes to the way Libor is set could trigger years of legal wrangling between derivatives counterparties to determine what effect those changes have on existing contracts."

New Libor will also be different. The Economist piece says: "LIBOR is oddly low compared with other benchmarks. It is also strangely stable: most banks in the sample changed their LIBOR estimates fewer than 30 times, even though they could have done so 182 times. The implication is that new LIBOR rates are likely to be higher and more volatile."

The other option would be heightened supervision from, for example, governments, but as this Motley Fool piece points out: "No government is going to want the added pressure of overseeing a new Libor, but even if one did step up, no one else would want a single government to have that much power. After seeing what a bunch of corrupt bankers were able to do, it's scary to imagine what could happen if crooked politicians got behind the wheel. "

No-one has yet proposed the most extreme alternative – to get rid of Libor altogether. In some ways, this might be a rational response because the system has proved too open to abuse and difficult to regulate. In this case, interested parties would substitute the Bank's base rate. However, this remains too complex a solution to form part of mainstream discussion of the future of Libor.


More on Mindful Money

Banking Crisis – Have the lessons finally been learnt?

Should Libor be scrapped?

Could the LIBOR riggers go to jail?

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