The LIBOR money-market rates, widely used around the world as the benchmark for interest rates on mortgages, credit cards and billions of dollars worth of other financial transactions, will be cleaned up and subject to substantial new regulations under official proposals announced Friday. But the way the rates are set won’t fundamentally change, and they will continue to be based on bankers’ estimates as much as real market transactions.
British regulators will step in to set tough new rules for the system, replacing ineffective self-regulation by the British Bankers’ Association but the regulators won’t run the rate-fixing process. Instead, that will be outsourced to an independent body. And the whole process will be streamlined to reduce the number of currencies and rates that are set on a daily basis.
The key proposals outlined Friday by Martin Wheatley, a managing director of Britain’s Financial Services Authority, are aimed at salvaging the scandal-ridden London Interbank Offered Rate. The British government is expected to implement them rapidly after a parliamentary debate.
LIBOR is at the heart of $300 trillion worth of financial transactions, but its reputation has taken a severe battering in the past few months on revelations of alleged massive manipulation of the rate by the bankers who set it. The scandal has shaken London’s reputation as a leading financial center.
The revelations arose from a case brought by the U.S. Commodity Futures Trading Commission and the FSA against Barclays, which paid a $450 million fine in June to settle manipulation charges. Another British bank, Royal Bank of Scotland, has since indicated publicly that it is likely to be fined. Fraud inquiries into the role of individual banks and bankers are currently underway in the U.S., the U.K., and Germany, among other countries.
In the uproar over the manipulation, regulators in Britain and the U.S. started taking heat for not intervening faster. The New York Federal Reserve, for example, was told in 2007 that something was amiss with the LIBOR mechanism. It expressed its concerns and recommendations to the Bank of England, which didn’t act on them.
“Today we press the reset button,” Wheatley said while announcing his proposals. “The disturbing events we have uncovered in the manipulation of LIBOR have severely damaged our confidence and our trust – it has torn the very fabric that our financial system is built on.”
Fundamentally, the existing system, which involves a group of bankers setting the rates daily based on estimates of their borrowing costs, will continue. Wheatley said that the LIBOR submissions should be supported by trade data, but he acknowledged that “some degree of judgement will have to be retained because even in the more liquid markets there is not enough daily data available to have a system in place that is entirely based on market transactions, particularly in times of stress.”
Oversight will be hugely strengthened. The FSA is proposing to introduce a new regulatory framework for the LIBOR market, with criminal sanctions for manipulation. Wheatley said that the key flaw in the past “was the inability of the system to manage conflict of interest.” An important consequence is that the British Bankers Association is losing its governance role in the process entirely. It will be replaced by another body, to be selected through a tender process. Possible candidates reportedly include NYSE Euronext and Bloomberg.
The number of currencies and rates that are set in the process will also be reduced, from 150 to about 20. That will be done by the elimination of some currencies from the system, including the Australian, Canadian and New Zealand dollars and the Swedish and Danish krone. That will allow participants – and regulators – to focus on the key rates that are set for the U.S. dollar, the euro, the Japanese yen and the British pound.
Missing from Wheatley’s proposals is one of the suggestions that the New York fed made to the Bank of England in 2008. Tim Geithner at the time sent the bank’s governor, Mervyn King, a two-page memo in May of that year, with six concrete steps that could be taken to shore up the system. The sixth, entitled “eliminate incentive to misreport,” suggested much greater public transparency about which banks were submitting what quotes. Wheatley’s proposals go the other direction: the publication of individual submission by individual banks will be delayed by three months.
Following publication of these proposals, LIBOR looks set to be reformed. It remains to be seen whether the reform goes far enough to calm the doubts of the legions of critics – and whether LIBOR itself can recover from the battering its credibility has taken.