LIBOR Interview with Bob Emerson

What is Libor and why does it matter?

“Rate underpins contracts worth 5 times global GDP”

LIBOR rates are one of the foundations of the finance industry. It is the interest rate that shows how much it costs for banks to borrow money from each other, and it matters because it underpins financial contracts worth an estimated $300 trillion worldwide – this is over five times global GDP

It was developed in the 1980s to simplify the pricing of interest-rate derivatives and syndicated loans, and it quickly became a vital reference point for the pricing of financial instruments.

Banks estimate what they would have to pay if they asked other banks to lend to them, and submit these guesses to the BBA. The rate is calculated daily, and once all the estimates are in, the extreme values are thrown out and the remainder averaged – this becomes LIBOR

Every weekday, trading screens are updated with that day’s new rates. The numbers are supposed to measure the interest rates banks pay when they borrow from each another.

What went wrong?

“Lack of operational control and regulation”

There are two clear factors that contributed to the downfall of LIBOR, but ultimately it comes down to a lack of operational control and regulatory oversight. As far back as 2008, a BIS study spotted days when financial risks spiked but LIBOR did not.

The first contributing factor, and perhaps the greatest, is that the system is based around the assumption that the estimates submitted by the banks are honest, but traders at these banks stand to win or lose millions based on the level of LIBOR. This ultimately led to systemic manipulation of the rate amongst a number of banks. This had apparently been going on since 2005.

For better or worse, this kind of mentality is the reality of financial markets – if a rule can be bent in order to make more profit for your company, and the regulatory oversight isn’t in place to provide the kind of punishment that will stop you from doing it, then there is always going to be a small percentage of people who take the risk.

The second factor is the credit crisis. The manipulation of LIBOR become increasingly more widespread in several major banks in the wake of Lehman and Bear Stearns, in order to make them appear more liquid. This is all about perception – even if a bank is financially sound, it can collapse in a second if people do not perceive it to be.

Ultimately this became a self-fulfilling prophecy – these banks were getting charged more to borrow money, and so they manipulated the rate further, and the cycle continued.

Is this the death of LIBOR?

“LIBOR is too ingrained in the industry to die”

Absolutely not. The death of LIBOR would push the financial services industry into a long, extended period of depression because it would require the re-tooling of every financial system and re-writing of every process surrounding interest rates.

LIBOR is here to stay, but away from the scandal other complementary indices have already become equally as important, such as Fed Funds and EONIA. Markets want valuations that are more consistent with the way trades are backed, and so benchmarks that rely on observable transactions are now being used in addition to LIBOR.

Many clients have spoken with us about their concerns of LIBOR going away, and while we are positioned to support any alternative benchmarks, we simply do not think this will happen.

Barclays is the only bank to have been fined so far, but it is understood that at least 15 banks globally are being investigated for possible Libor manipulation. What are the consequences?

“Setting of LIBOR is now a regulated activity”

On the basis of the Wheatley Report, The Treasury has now announced that the setting of LIBOR will become a regulated activity and submitting false information or otherwise tampering with the interbank rate will be a criminal offence.

With the amount of attention this scandal has received in the media and by the government, and with this new regulatory oversight, it is unlikely that LIBOR will ever be manipulated in the same way again.

There will undoubtedly be a few more substantial fines handed out to some of the big banking players, but soon enough another benchmark will find itself in the news. What is required is a greater regulatory oversight of the entire industry at a higher level – the punishments need to be strong enough to act as a deterrent.[[[PAGE]]]

Those involved in setting the rates had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. How likely is it that this structural motivation will change?

“Without regulation, human nature will prevail”

This motivation will never change. It is human nature to want to do as well as you possibly can in your chosen profession, and if the correct level regulatory oversight is not in place, then the deterrent simply doesn't exist.

If the only possible punishment for manipulating a rate is a fine of a few thousand pounds that is inconsequential when compared to the bonus you stand to make, then you will carry on doing what you’re doing and take the hit. If the punishment is a couple of years in jail, then you are more likely to reconsider your actions.

The FSA needs to consider the punishment not only for those who attempt to manipulate LIBOR, but all other rates too. This should have happened a long time ago.

Is it still possible to restore confidence? How?

“Swift decisive action is crucial for confidence”

Yes, absolutely. Swift and decisive action by market participants, regulators and politicians is crucial. The Treasury has accepted the Wheatley report’s recommendations, but it is not essential that measures are put in place immediately – before the end of the year, if not earlier. Given that the benchmark’s flaws have been visible for years, the changes have been far too long in coming.

Martin Wheatley, the FSA's head of conduct, recommended reforming rather than scrapping LIBOR. The report seems to be a very practical and politics-free assessment of the situation, however it didn’t come into being until the problem came to light – we need preventative measures, not cures, if we are to restore confidence in the financial services industry as a whole.

This whole episode has highlighted the need for regulation at a much higher level, with much more serious punishments for anyone considering manipulating a rate such as LIBOR. There are many other rates that could be manipulated, and addressing each of these individually is not a sustainable option – instead, a broad regulatory framework must be put in place. However, this must not over-regulate the markets to a point where we lose the very benefits of the free market system.

The restoration of public confidence in the banking system is crucial the economic recovery. Perception is just as important as reality, and this relies on responsible, informed coverage of the situation by the global media. The LIBOR ‘scandal’ created a wave of hysteria, stoked in misinformed reporting of the issue, when in fact the impact it had on the real world economy was fairly limited compared to the events of 2008.

A lot of measures have been taken in the last four years to restore public faith in this industry, but we cannot make any progress if the media resets the clock to zero in the wake of every issue such as this.

The government’s changes to legislation will ensure that those that attempt to manipulate Libor face the full force of the law. But this is just one part of the process, the banks and the BBA will have to play their part to ensure that reform is effective and Libor’s reputation is restored.