Can we rely on LIBOR?

Society has lost its trust in the financial sector. Should we overhaul LIBOR?

IN A RECENT article by Bloomberg Businessweek, assistant managing editor Brian Bremmer reports that investigators in America, Canada, Japan, the UK, and the EU are trying to determine whether a handful of brokers and traders have manipulated LIBOR.

At this stage, it is unclear whether the investigations will uncover any wrongdoing, and Bremmer notes that no banks or individuals have actually been charged.

If banks have engaged in collusive behaviour to manipulate LIBOR, then this is a serious cause for concern.  Bremmer highlights the importance of LIBOR by explaining that it is “a key benchmark rate that affects the price of $350 trillion worth of securities and loans around the world.” Indeed, the British Banker’s Association notes that LIBOR “is the primary benchmark for short term interest rates globally. It is written into standard derivative and loan documentation such as the ISDA terms, and is used for an increasing range of retail products.” To drive the message home, Bremmer notes that this “may include your car loan or even your home mortgage.”

UK regulators and global banks are discussing an overhaul of the calculation and regulation of LIBOR, which is currently set by a small group of financial professionals with little regulatory oversight.  How concerned should we actually be?

On first glance the lack of regulation sounds worrying, however there does not appear to be any real cause for concern.

The current method of calculating LIBOR appears to be robust and reasonable, and here are three reasons why.

1. The LIBOR calculation

LIBOR, the “London InterBank Offered Rate”, is a benchmark which indicates the average rate at which leading banks can obtain unsecured funding in the London interbank market. LIBOR is published by Thompson Reuters each business day for 10 different currencies with 15 maturities for each currency (i.e. 150 rates in total).

The rates for each currency are determined by a panel of up to 18 contributing banks, which submit their rates to Thomson Reuters between 11.00am and 11.10am each business day. After it receives submissions, Thomson Reuters then calculates LIBOR by using a trimmed arithmetic mean. It ranks each submission in descending order and excludes the highest and lowest 25%. It then takes the arithmetic mean of the remaining contributions to determine LIBOR.

This method of calculating LIBOR appears to be reasonable because LIBOR is intended to indicate the rate at which banks can obtain unsecured short-term funding in the London market.  It is not clear whether there is anyone better placed to determine this rate than a panel of up to 18 leading banks. Banks outside the UK currently use LIBOR in loan documents to estimate their cost of funding because London is a key financial centre and LIBOR is typically a reliable benchmark. If a bank’s cost of funding changes dramatically in the short term, it is normally able to rely a “market disruption” clause to adjust rates upwards.

2. Bank bias

Some commentators have criticised LIBOR by arguing that individual banks may have a commercial incentive to over or under-state the rate it submits to Thomson Reuters.  This is true.  Individual banks may have commercial incentives to over or under-state their cost of funding.  However, this is not a reason to overhaul LIBOR. Rather, LIBOR is designed to deal with bias from banks because of the way it is calculated.

When banks submit rates to Thomson Reuters, the highest or lowest rates are excluded. This means that a bank which is biased (and reports an unrealistically high or low rate) will not affect the actual LIBOR calculation. The British Banker’s Association notes that “[t]he decision to trim the bottom and top quartiles in the calculation was taken to exclude outliers from the final calculation. By doing this, it is out of the control of any individual panel contributor to influence the calculation and affect the [LIBOR] quote.”

After the outliers are trimmed, LIBOR is calculated by taking the average of the remaining rates. Although a bank may have a commercial incentive to slightly over or under-state its cost of funding, different banks will typically have different incentives because they have different trading positions. As a result, the averaging process further reduces the effect of individual bank bias.

3. Trust is the basis of social institutions

This may be the crux of the issue.

While the LIBOR calculation appears reasonable and helps to correct for a certain amount of reporting bias by individual banks, there is nevertheless a strong dissatisfaction with the financial sector.

The global financial crisis of 2008 was caused by an act of deception (or rather, many acts of deception). Wall Street investment banks worked financial magic by turning large numbers of sub-prime mortgages into AAA-rated mortgage backed securities. To understand the extent of the fraud, this is the equivalent of a used car salesman taking a worthless car, painting over the rust, winding back the odometer, and then selling it for 10 times its true value. And then doing this again, a billion times.

As a result, society has lost its trust in bankers and the banks they work for. And this trust will take years to rebuild.

Society has lost its trust in the financial sector, but does this justify overhauling LIBOR?

If you have an opinion, please comment below.