March 7 (Bloomberg) -- The value of about $360 trillion in financial contracts, ranging from derivatives to adjustable-rate mortgages, depends largely on a benchmark -- known as the London interbank offered rate -- that is demonstrably broken.
Regulators and global banks are trying to figure out how to fix it. They should be looking for a replacement instead.
Perhaps no financial indicator is more important for global finance, and less understood by the people it affects, than Libor. Every weekday morning London time, a panel of the world’s largest banks reports how much it would cost to borrow from other banks in various currencies and time periods, ranging from overnight to a year. An adjusted average of those rates -- the three-month and six-month dollar loan rates are the most widely used -- determines the size of payments on corporate and mortgage loan worldwide. In times of crisis, Libor also serves as an indicator of stress in the banking system: The more that banks are paying for short-term loans, the more trouble they’re in.
Problem is, banks have powerful incentives to fib about their borrowing costs -- a flaw that has become the focal point of numerous civil lawsuits, a criminal investigation by the U.S. Justice Department and a multinational regulatory inquiry into possible manipulation of Libor. Troubled banks can make themselves appear healthier by artificially lowering their reported borrowing rates, which are made public. Manipulating Libor can also help banks that are major players in derivatives markets. Hundreds of millions of dollars can be made on differences of as little as a quarter of a percentage point.
Academic studies suggest that such incentives are skewing Libor. In one, economists at the Federal Reserve Bank of New York estimated that, during the financial crisis, the rates reported by banks in the Libor panel were as much as 0.3 percentage point lower than their actual borrowing rates. A separate study by economists Connan Snider of the University of California at Los Angeles and Thomas Youle of the University of Minnesota found that at least one bank’s Libor quotes tended to err in directions that benefited its positions in derivatives markets.
The British Bankers' Association, the trade group that oversees Libor, attempted to overhaul the benchmark in 2008 after news reports shed light on its flaws. Clearly, it didn’t work. The chances of success, given another try, are slim. One major reason is that the BBA is conflicted: Representatives of the reporting banks, for example, lead the BBA committee responsible for Libor. Beyond that, it’s difficult to find actual borrowing rates to verify independently what the banks are reporting.
Hence, the world needs a new benchmark. Ideally, it would reflect an actual trading market rather than the “what if” quotes that underpin Libor. The market should be very active and used by a wide variety of participants, making it difficult to manipulate. It should also be useful for banks and other institutions that want to hedge against changes in interest rates.
The leading candidate is the market for so-called general collateral repo loans -- loans that banks, investors and other participants take out against good collateral, such as U.S. Treasuries. The Depository Trust Clearing Corp., owned by a wide-ranging group of financial institutions, has already started publishing a daily index of the interest rates on overnight repo loans. Separately, important players in that market could soon be generating reliable repo rates for longer terms, such as three months.
Any transition from Libor to a new benchmark will take a long time. Traders will resist change. And even if all new contracts are tied to repo rates starting in the near future, some of the loans that reference Libor will be around for decades to come. But those are small obstacles in the way of a change that could have major consequences, not the least of which would be an honest benchmark for interest rates paid by millions of corporations and homeowners.
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