Britain’s top financial watchdog delivered a 10-point plan to fix Libor, but stopped short of scrapping the benchmark interest rate in a much-awaited reform of a system plagued by scandal.
“The system is broken and needs a complete overhaul,” said Martin Wheatley, head of the Financial Services Authority (FSA).
Wheatley acknowledged problems with the London interbank offered rates, but said Libor is so deeply entrenched in the financial system that it cannot be easily replaced.
There are no better alternatives now and any transition to a new benchmark would be difficult, he said on Friday.
Longer term, it makes sense for market participants to examine whether there are other possible benchmark rates, Wheatley said.
The plan, which includes oversight by a new panel, marks regulators’ first effort to fix the tarnished benchmark, but rule makers have to thread the needle carefully.
On the one hand, they must restore confidence in the financial system; on the other, they cannot take steps that are too radical without creating big trouble with existing transactions that use the benchmark.
More than $300 trillion of contracts and loans – from U.S. mortgages to Japanese interest-rate swaps – refer to Libor.
“Bringing Libor under an independent regulator will take away the notion that this was a system run by banks for the benefit of banks,” said Matthew Fell, director for competitive markets at the Confederation of British Industry lobby group.
“Focusing it on the most liquid trades will drastically reduce the scope for any manipulation, particularly at times of market stress.”
The UK government and Bank of England said the changes should proceed without delay. Greg Clark, financial services minister, said the proposals were considered, proportionate and credible.
CHARGES OF MANIPULATION
Multiple banks have been accused of trying to manipulate Libor, a series of rates set daily in London. Barclays in June agreed to pay $453 million to U.S. and British authorities to settle allegations that it tried to move Libor to help its trading positions.
Wheatley’s program for reform includes auditing banks that contribute data used to calculate the rates, to ensure they are not submitting false rates to benefit trading positions.
Libor, which is meant to reflect the rates at which banks borrow from one another, will be based on actual borrowing transactions. Previously, banks could estimate where they think they would borrow, which left room for manipulation.
Transactions will be recorded with regular external audits of banks that participate. Bank employees making Libor submissions will have to be approved by the FSA. Wheatley is looking for authorization to criminally sanction those who attempt to manipulate the rate.
Wheatley said he had taken legal advice and does not expect a rash of legal disputes or any disruption in the transition to a new system, as there will be no change to the definition of Libor and no change to the timing or mechanism for submitting quotes.
Reuters parent company Thomson Reuters collects information from banks, and uses it to calculate Libor rates for 10 currencies and 15 maturities according to specifications drawn up by the British Bankers Association (BBA).
SHRINKING THE NUMBER OF RATES
Rates that are infrequently referenced in trades, such as Australian and Canadian dollar rates, will be phased out, Wheatley said. Maturities that are infrequently used, such as four, five, seven, eight, 10 and 11 months, will also be ended.
The reductions will shrink the current number of Libor rates set daily to 20 from 150. Rates that are rarely traded are easier to manipulate.
More banks will be required to submit their borrowing rates. “Libor requires collective responsibility if it is to work effectively,” Wheatley said.
As expected, the BBA, which had overseen the rate, will be replaced with a new, as-yet unidentified oversight panel.
“The British Bankers’ Association clearly failed to properly oversee the Libor setting process and should take no further role in the administration and governance of Libor,” Wheatley said.
The BBA said it worked closely with Wheatley on his review and had strongly stated the need for greater regulatory oversight of Libor and tougher sanctions against manipulation.
A major remaining problem is that in financial crises, such as the one in 2008, banks cease lending to one another, effectively removing data needed to calculate Libor.
“There isn’t enough transaction data during a financial crisis,” said Rosa Abrantes-Metz, principal at Global Economics Group and adjunct professor at New York University’s Stern School of Business.
Mervyn King, governor of the Bank of England, said: “Over the medium to long term, further thinking will be needed to meet the challenge of benchmarks based on thinly traded markets, especially when they are quote-based.”
The reforms come amid more crackdowns on the banks that submitted rates used to calculate Libor. Royal Bank of Scotland is expected to be next to settle Libor charges, with other banks to follow.
Britain’s government commissioned Wheatley to report on reforming Libor and is expected to back the findings in full. Legislative changes will be inserted into a financial services bill now being approved by parliament.
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