A failure to fix the “broken” London interbank offered rate risks long-term disruptions to financial markets, according to the strategist who first brought attention in 2008 to the possibility that the benchmark was understating lending costs.
“The accuracy of Libor is a matter of keen interest to everyone, from homeowners in Peoria, Illinois, to the largest companies in the world,” Scott Peng, the head of global portfolio solutions at SECOR Asset Management LP, wrote yesterday in Investment & Pensions Europe. “Libor may be broken, but it can still be salvaged with some major structural changes.”
Libor’s reputation has been dented by Barclays Plc’s admission that it submitted false rates for the benchmark for financial products valued at $360 trillion worldwide. Other banks have lowballed their submissions, according to testimony before British lawmakers last week from Robert Diamond, who resigned as chief executive officer after Barclays was fined 290 million pounds ($451 million) in the scandal.
As head of U.S. interest-rate strategy at Citigroup Global Markets Inc. in New York, Peng co-authored a note titled “Is Libor Broken?” on April 10, 2008. The report, which triggered global focus on the risk that the benchmark was mispricing bank lending rates, said European banks were likely submitting lower-than-actual transacted rates to avoid “being perceived as a weak hand in a fragile market.”
Three-month Libor, 2.71 percent at that time, was likely too low by between 20 basis points and 30 basis points, Peng wrote in the Citigroup note with co-authors Chintan Gandhi and Alexander Tyo. The rate was 0.46 percent yesterday. A basis point is 0.01 percentage point.
London-based Barclays, along with some of the world’s biggest financial institutions, is facing an international investigation into an attempt by lenders in the U.K. and U.S. to rig Libor.
The Commodity Futures Trading Commission, among the regulators that levied the fine against Barclays, has laid out a hierarchy of transactions or instruments that panel member banks should consider when deciding on what rate to submit in the daily Libor fixing.
Libor is derived from a survey of London banks conducted each day by Thomson Reuters Corp. on behalf of the British Bankers’ Association. Bloomberg LP, the parent of Bloomberg News, competes with Thomson Reuters in selling financial and legal information and trading systems.
Lenders are asked how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies including dollars, euros, yen and Swiss francs. After a set number of quotes are excluded, those remaining are averaged and published for each currency by the bankers’ association before noon.
Libor, to be a viable money market benchmark, must be redefined as a transaction-based rate, Peng, who is based in New York, wrote in the op-ed. Regulators and central banks must also take steps to foster a secondary market for short-term bank debt with increased liquidity and transparency, according to Peng.
Finally, a permanent bank-funding backstop must be created, similar to temporary programs created in the U.K. and U.S. during the crisis, such as the Federal Deposit Insurance Corp.’s Temporary Liquidity Guarantee Program.
As the financial system reeled with the crisis that followed the collapse of the U.S. subprime mortgage market, banks routinely misstated borrowing costs to avoid the perception they faced difficulty raising funds, Tim Bond, then head of asset allocation at Barclays Capital, said in a Bloomberg Television interview in May 2008.
Investors also speculated that the global benchmark was taking place as early as 2008. Respondents in an ACI-The Financial Markets Association survey taken May 2008 said Libor didn’t reflect actual money-market rates, with the greatest discrepancies involving rates based in U.S. dollars.
Eighty-two percent of the 106 respondents agreed that Libor didn’t represent actual rates in money markets, according to the 2008 survey conducted in conjunction with the 47th annual ACI World Congress in Vienna from May 29 to May 31. Of those members noting a discrepancy, 24 percent indicated inconsistencies mainly involved U.S. dollar Libor, which varied by 15 to 25 basis points from actual rates.
Timothy F. Geithner sent Bank of England Governor Mervyn King recommendations in 2008 to revamp Libor. Geithner wanted procedures to prevent “misreporting,” and the bankers’ association, which was reviewing Libor at the time, said it would take the recommendations on board.