Wheatley’s Review Draws the Right Conclusions About Libor
The U.K. finally has a plan to overhaul the London interbank offered rate, the deeply flawed benchmark that has, for more than two decades, set the payments made worldwide on mortgages, corporate loans and derivatives.
Given the constraints, and with some important caveats, they’ve done a respectable job.
Martin Wheatley, the U.K.’s chief financial regulator, faced a quandary in early July when he started a review of Libor amid overwhelming evidence of manipulation. He had to tread carefully, lest changes render null and void the more than $300 trillion in contracts tied to the benchmark. At the same time, he had to do something to restore trust in one of the world’s most important financial indicators.
Created in the 1980s, the Libor system could hardly have been better designed for corruption. The calculation of the benchmark, which is supposed to provide an objective picture of interest rates across 10 currencies and 15 time periods, relies on self-reported estimates from banks that have huge incentives to game the system. The same banks control the British Bankers’ Association, the trade group that owns and purports to police Libor. The entire process exists completely outside the purview of regulators. Not surprisingly, misbehavior ensued. Global investigators are only now beginning to understand the extent of the mischief.
1) The BBA will be removed from the picture, and U.K. authorities will hold an open competition to find a new administrator. (Disclosure: Bloomberg LP, the parent of Bloomberg News, is a competitor of Thomson Reuters Corp., which conducts Libor surveys on behalf of the BBA. Bloomberg has proposed its own alternative to Libor.)
2) Bankers involved in setting Libor will be subjected to regulatory oversight, and manipulation will become a criminal offense.
3) The number of Libor maturities and currencies will be pared down to those in which borrowing actually occurs, a move intended to take some of the guesswork out of banks’ interest-rate estimates.
Unfortunately, Wheatley stopped short of one measure that would have greatly improved transparency: requiring banks to report actual borrowing transactions, against which the public could check the veracity of the estimates that banks submit. Instead, he has recommended that even the publication of individual banks’ estimates be put on a three-month delay -- as opposed to being posted immediately. The change is intended to mitigate the stigma banks might suffer if they report rising borrowing costs during times of crisis.
As a result, it will actually become more difficult for outsiders to assess Libor’s reliability in real time. If banks are reporting honestly, it’s hard to understand why they would object to the publication of the relevant information from actual transactions. This could be done with a three-month delay, as a quid pro quo for postponing the publication of the banks’ Libor submissions.
Ultimately, the market will be better off moving away from Libor and other survey-based benchmarks to ones that rely on observable transactions. Criminal prosecutions of those responsible for undermining Libor could also go a long way toward changing a culture that encouraged manipulation.
That said, following through on Wheatley’s recommendations should be enough to keep Libor going until a viable replacement emerges. Given that the benchmark’s flaws have been visible for years, the changes have been far too long in coming.
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