With several parallel initiatives among policy makers and regulatory authorities on the setting of financial benchmarks, the industry appears to be getting down to business in advancing reform of the London Interbank Offered Rate (LIBOR). A number of organisations are now competing to take over the administration of LIBOR from the British Bankers Association (BBA).
In late February, the UK Treasury announced the membership of an independent Committee, chaired by Baroness Hogg, to select a new LIBOR administrator – one of the principal recommendations of the Wheatley Review of LIBOR, which the UK Government accepted in full last year.
Members of the BBA, which first began publishing LIBOR in 1986 and has overseen the process since, voted at an Extraordinary General Meeting on 26 February to cede this role to the winners of the tender process, which is expected to be completed later this year.
In essence, LIBOR is an estimate, based on aggregated data, of the rate at which banks lend unsecured funds to each other on the London interbank market. The erosion of trust in its accuracy stems on the one hand from evidence of misreporting dating back to 2005 and on the other from the decline in unsecured interbank lending activity post-crisis.
In a recent address to the Global Financial Markets Authority, Gary Gensler, chairman of the US Commodities Futures Trading Commission (CFTC) and a trenchant critic of the continuing role of LIBOR in the industry, observed that the interbank, unsecured market has changed dramatically. “Some say that it has become essentially non-existent. In 2008, Mervyn King, the governor of the Bank of England, said of LIBOR: ‘It is, in many ways, the rate at which banks do not lend to each other’,” he noted.
It is nevertheless still used as a base rate for setting other interest rates around the world and is a key benchmark that underpins a variety of derivatives used by institutional investors. The US Council on Foreign Relations in its LIBOR backgrounder cites a figure of over US$800 trillion in securities and loans linked to LIBOR globally.
In his presentation to the GFMA, Gensler noted an increasing shift from unsecured to collateralised interbank borrowing, exacerbated by the European debt crisis. The introduction of an asset correlation factor in Basel lll, requiring additional capital when a bank is exposed to another bank, and the introduction of provisions for a liquidity coverage ratio, will reinforce this trend, he added.
“Given what we know now, it’s critical that we move to a more robust framework for financial benchmarks, particularly those for short-term, variable interest rates,” said Gensler. “There are alternatives that market participants are considering that are grounded in real transactions. These include the overnight index swaps rate, benchmark rates based on actual short-term collateralised financings, and benchmarks based on government borrowing rates.”
Gensler nevertheless acknowledged that moving on from LIBOR might be challenging. “Today, LIBOR is the reference rate for 70% of the US futures market, most of the swaps market and nearly half of US adjustable rate mortgages,” he noted.
FSA’s mea culpa (but not maxima)
Meanwhile, in early March, the Financial Services Authority (FSA) published its Internal Audit Report on LIBOR covering the period January 2007 to May 2009. The Report identifies that the FSA, at all levels of management, was aware of severe dislocation in the LIBOR market over that period though it says this reflected market conditions and would have occurred even if ‘lowballing’ by some of the reporting banks had not occurred.
“As the financial crisis developed in 2007 to 2008, the FSA’s bank supervisors were primarily focused on ensuring they understood the prudential implications of severe market dislocation,” said Adair Turner, chairman of the FSA. He pointed out that the FSA had no formal regulatory responsibility for the LIBOR submission process and that, as a result, “the FSA did not respond rapidly to clues that lowballing might be occurring”.
LIBOR submission and administration will be regulated activities from 1 April 2013 and the FSA, together with the new LIBOR administrator resulting from the tender process, will agree appropriate market monitoring and oversight for the benchmark. Thomson Reuters, Bloomberg, NYSE Euronext, and Rate Validation Services (RVS) are all believed to have expressed formal interest in assuming this role.
Beyond the UK, policy makers are also revisiting the underpinnings of financial benchmarking with a view to promoting a more robust approach. In January, an IOSCO task force published a ‘Consultation Report on Financial Benchmarks’. The comment period closed on 11 February and a final report is expected to be published this spring. Virtually in parallel, The EBA and ESMA released a joint consultation paper, inviting comment by mid-February.
In its submission to IOSCO, the International Capital Markets Association, (ICMA) expressed particular concern at the potential for disruption in the market that could arise if changes to indices were to lead to issues regarding the continuity of existing securities contracts. “Broadly speaking, the ICMA considers that where market participants have chosen to utilise a certain index-based reference, this is reflective of the fact that it is commercially suitable,” ICMA commented. “This does not mean that alternatives would not prove suitable in some instances, but if there already were significantly better alternatives it seems reasonable to expect that the market would have migrated towards their utilisation.”