Libor reforms revealed: regulation, not replacement
The focus narrows, and anti-fraud measures are introduced, but the interbank rate is sticking around.
The managing director of the Financial Services Authority, Martin Wheatley, is to announce his planned overhaul of the Libor interbank lending rate today, in a speech in the City.
Describe the rate as "broken", Wheatley nonetheless concluded that a replacement was impossible, and so set out instead for radical reform, telling the Financial Times:
We started out with an open mind [about whether it] would be possible to move to a different rate, and the answer is no.
As a result, the methodology by which Libor is set will remain largely unchanged: a panel of banks will continue to submit daily estimates of their borrowing costs, although the body which accepts the estimates will be a fully independent administrator, after the British Bankers Association resigned its role in the process earlier this week.
In order to ease some of the worries about Libor, the focus of the rate will be vastly narrowed. Five currencies will be dropped, leaving it covering just the US dollar, yen, British pound, Swiss franc and euro; and 130 of the 150 daily fixings will be dropped.
The hope is that by focusing only on those currencies and maturities which are regularly traded, the estimates the banks submit will be based on real borrowing costs, rather than hypotheticals.
In addition, the number of banks asked to submit to the rate-setting mechanism will be increased from the 20 or so currently involved. The hope is that this will minimise the influence of individual institutions on the overall rate, and thus dial back the damage caused by another rogue bank.
The real anti-fraud efforts manifest as more minor changes in the process, but could have a real chance of dissuading future banks from going down the same road as Barclays. The bank will have to seek regulatory approval for the individual responsible for the submissions, and will be required to demonstrate to the regulator how they made their estimates.
This sort of demonstration was largely impossible under the previous mechanism because of the number of illiquid markets the banks were required to submit estimates in; with the narrower focus, the hope is that the regulator will be able to accurately judge whether the estimates provided are a realistic reflection of the banks' borrowing costs.
The most important change is counter-intuitive for a fraud-prevention measure. Although "sunlight is the best disinfectant", the reforms will remove a bit of transparency from the process, allowing banks to keep their submissions secret for three months after they have made them. This strikes at the heart of the ongoing investigations into manipulation of the rate: although some of the fraud was done with the aim of a direct payoff, much of it was done as a form of reputation management. Banks knew that if they submitted overly-high estimates, they would be viewed as admitting they were unsafe to lend to – and so they faked their rates. The increased privacy around submissions ought to remove that motivation.
Wheatley will conclude his speech by saying that:
The system had in-built conflicts of interest from the start - banks could submit what they wanted - and with traders' bonuses dependent on the Libor rate, and no bank wanting to be seen as vulnerable in such a transparent system, too many people had a vested interest in gaming the system.