British Bankers Association forced to review LIBOR calculation

British Bankers Association forced to review LIBOR calculation

Published:

Author: Rachel Griffiths

The British Bankers Association (BBA) has announced the next steps in its review of how the London Inter Bank Offered Rate (LIBOR) is calculated, following allegations by regulators on various continents that banks have colluded to manipulate LIBOR.

What is LIBOR?

LIBOR was established by the BBA in conjunction with other bodies in the 1980s. As London grew as a financial centre, there was demand for a measurement of the real rate at which banks could borrow from each other. Now more than 20 per cent of all international bank lending takes place through banks' offices in London.

LIBOR purports to provide an objective measurement of the cost of bank borrowing which is then passed on to customers - it is a daily snapshot of an average notional rate.

LIBOR is used extensively across the globe. As well as being referenced in many documents including loan and mortgage agreements, futures and options exchanges, it is considered an indicator of future central bank interest rates and potential strain in money markets.

Who sets LIBOR?

LIBOR calculation is based on an average of rates provided daily by banks on the LIBOR panel. These banks should be the most active and have the highest credit ratings in the cash markets. They are selected by the independent Foreign Exchange & Money Markets Committee (FXMMC).

Of the figures provided, the highest and lowest four are excluded, and an average of the remainder is calculated by Thomson Reuters and released to the market at 11:00am each day.

How is LIBOR calculated?

The figures provided by the panel banks are based on the answer to the following question:
"At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?"

The banks provide a hypothetical answer for the cost in ten different currencies, for specified periods, taking into account relevant market influences. LIBOR represents an unsecured loan rate. In reality many banks are not able to obtain unsecured borrowing except on a very short term (i.e. overnight) basis, if at all, and so LIBOR effectively represents an opinion poll.

Current problems

A number of regulators across the globe have been investigating claims that LIBOR figures may have been manipulated by the banks in order to provide a misleading indication of their financial stability.

As the figures provided by the banks are notional, based on a market which does not exist, regulating them is inherently difficult.

This has resulted in a general lack of confidence in LIBOR, as well as claims relating to contrived data.

On 28 March the BBA announced that the review they have agreed to undertake will focus on:

  • The financial instruments used for defining the rate
  • A code of requirements for those who contribute to setting the rate
  • Strengthening the statistical underpinning of contributions

The steering group leading the consultation includes Barclays, Credit Suisse, HSBC, Lloyds Banking Group and RBS. HM Treasury, the Bank of England, the FSA and the FXMMC will also be involved.

Potential alternatives

A final reform package is likely to be published mid-summer 2012. At this stage it is unclear to what extent the current process will be modified.

Suggestions for change have included:

  • Basing figures on actual trades - as there are very few long term trades, this would probably require using an overnight rate. This would be of limited use to the markets and is likely to skew figures as, in reality, only the most credit worthy institutions can obtain funding
  • Increasing the number of institutions which set the rate - the euro-zone equivalent to LIBOR is set by 44 banks (LIBOR uses a maximum of 18) and is based on how much a prime bank would pay to borrow funds, rather than each institution's own submissions. This would still require an element of guesswork
  • Opening the process to independent verification - this does not solve the problem of figures being provided on a hypothetical basis but creating safeguards to ensure the consistency of a bank's submissions may provide a useful control
  • Allowing banks to provide completely anonymous submissions - this may reduce the incentive for them to inflate their financial robustness artificially (currently the figure indicates the amount the respective bank would have to pay to borrow)
  • Asking two banks at what rate they would lend to each other, rather than at what rate they borrow at - it would be difficult for banks to be generic in answering this question as the answer depends on the risk profile of each borrower
  • Insisting on tighter controls within banks on who is consulted and informed about the rate and who provides the estimate - the anticipated review of financial instruments used as reference points should act to strengthen any controls that are implemented

Conclusion

Finding an alternative to LIBOR that is verifiable over an applicable term will be extremely difficult.

Any changes to the LIBOR process will not be easy to implement. It is deeply embedded, widely used, and written into various agreements, many with years left to run.

It is not clear whether these agreements will be invalidated if the methodology of calculation changes. The process will be problematic for both banks and their customers who borrowed on terms which they thought they understood.

There is also a real risk that significant change destabilises markets in an environment that is already wary of bank lending. Therefore our view is that any changes are likely to be gradual and incremental rather than a complete overhaul of the way that rates are set.