What is the alternative to LIBOR?

After the LIBOR debacle and the money laundering affairs of Standard Chartered and HSBC, the UK’s banks reputation are in the toilet.

Now we have to rebuild, and this is where it gets interesting and challenging.

After claiming that the Americans were holding our banks to ransom last week, we now see the potentially true motivation of the US investigations are to undermine the UK’s role in global banking.

This is certainly the sentiment being aired in the UK media and political circles.

Yes, our banks should NOT flout US money laundering rules, but those rules can sometimes be unclear when you are a global bank, especially as domestic US banks are just as culpable of the laundering issues as the UK ones.

It is noteworthy however that the money laundering attack came hot on the heels of the LIBOR headlines.

It’s called pulling a rug, as we are now looking at what happens next and find it’s the Americans vying to replace LIBOR with their own system.

There are two US proposals to replace LIBOR. 

The first is based upon overnight index swaps. 

These are contracts based on the federal funds effective rate, which is the interest US banks charge one another on overnight loans.

The Federal Reserve records the underlying loans and publishes a weighted average interest rate every day.

The problem is that it is an illiquid market, with banks tending to pull out of the market during times of stress.

This means it is easily manipulated as a market that is too small to provide a true picture of borrowing costs.

The alternative is to use the much larger market for repurchase agreements, known as repos. 

These are overnight loans made against real collateral such as US Treasuries.

Every day, a weighted average of the actual interest rates paid on these loans is published by the Depository Trust and Clearing Corporation (DTCC), the central clearing house for the US markets. 

As a result, the repo index is seen to be far more reliable, as it is based upon real trading, secured by collateral and has the majority of the trades processed through a central counterparty that protects the system against default.

Nevertheless, creating a new market base will be challenging, especially as repo is a market that is “clubby and lacks transparency”.

More fundamentally, moving an $800 trillion market that bases its benchmark on one indices to another is not going to happen in the near term.

And the real question is: do we really need to replace LIBOR?

LIBOR worked at one point, so what went wrong?

Governance.

The real issue with LIBOR is that when the markets were stressed and tested, the banks could manipulate the rate as it was purely based upon a view of interbank rates rather than real interest rates.

That appears to be the conclusion of the UK Government’s investigations, with the Treasury Select Committee releasing their preliminary findings over the weekend.

A few key excerpts from the report show that the system was broken:

“The FSA and the Bank of England were engaged in crisis management, alert to the possibility of further bank failures, rather than LIBOR manipulation. This is understandable, given the circumstances of the financial crisis, but with the advantage of hindsight constitutes a failing by the authorities.” 

“The evidence suggests that the Bank of England was aware of the incentive for banks to behave dishonestly, yet did not think that dishonesty was occurring. Nor did it appear to have asked the FSA to check to see if such dishonesty was occurring. With hindsight this suggests a naivety on the part of the Bank of England. They were certainly relatively inactive. This confirms evidence from other Treasury Committee inquiries of the dysfunctional relationship between the Bank of England and the FSA which existed at that time to the detriment of the public interest.”

“Unlike the Bank of England, the Financial Services Authority was the prudential regulator. Its shortcomings at this time are therefore far more serious. The Committee is concerned about the FSA’s failure to appreciate the significance of market rumours relating to the artificial rigging of the LIBOR rate. We therefore look forward to the result of the FSA’s internal investigation, the existence of which was disclosed in evidence to us. The Committee will want the findings of that investigation to be published.”

“Barclays did not need a nod, a wink or any signal from the Bank of England to lower artificially their LIBOR submissions. The bank was already well practised in doing this.”

During the recent crisis, it therefore became a cultural issue that banks could state rates that were not their real view, but the view that would be most favourable towards their own trading.

That’s wrong, but it kind of makes sense.

So how do we make it right?

Well, there were calls to improve the system during the crisis.

According to emails released by the Bank of England, the BBA were keen to get the Bank and the Financial Services Authority on board to improve the breadth and depth of rate setting.

From the Financial Times:

An email from the FSA, querying why the BBA wanted to refer to public agencies in its proposals on the Libor-setting process:

The BBA response:

And finally from the Bank:

As can be seen, the BBA had huge concerns about the governance process of LIBOR during the crisis and this is definitely going to be part of the answer that Martin Wheatley, the forthcoming head of the Financial Conduct Authority (FCA), will deliver in his reforms of LIBOR being announced in September.

Whatever these reforms are, it will have two key factors: better governance and more ties to real market movements.

A key index should not be based upon best guesswork but real trading, and real and resilient regulators and supervisors should oversee such trading.

That’s what Mr. Wheatley will announce and, as a result, will aim to defend and deflect the US alternative.

Postnote: What is LIBOR?

Bloomberg published an excellent piece on the background to how LIBOR arose, which I am republishing here.

This system was developed by the BBA in 1985, but the interbank rate in London, which has been referred to as LIBOR since the early 1970s, first became a significant global benchmark in the early ’60s. London was then becoming the center of a growing market for dollar deposits and dollar loans -- known as Eurodollars -- which were held by individuals and institutions outside the U.S. and were thus free from oversight by American regulators.

In the early ’60s, the fragility of the Bretton Woods system of fixed exchange rates pushed U.S. policy makers to restrict international bank lending originating within the U.S. The Federal Reserve, along with the Kennedy and Johnson administrations, feared that dollar outflows linked to international lending would endanger U.S. dollar reserves and thus the global financial system.

This fear, most now agree, was unfounded, and ironically domestic regulation simply pushed American bankers and multinational corporations to relocate these functions offshore. London banks had been lending Eurodollar since the early 1950s, and the city’s tradition as a haven for transnational finance made it a logical site for a market in unregulated dollars. Large corporations seeking to finance international operations, as well as nations looking for dollars to help make up balance- of-payments deficits, turned to the London Eurodollar market through the ’60s and ’70s.

The structure of this market brought LIBOR to the fore. Eurodollar deposits at London banks were usually made on a short-term, fixed interest-rate basis. To match their loan and deposit maturities, banks lending Eurodollar structured their loans to roll over, usually every six months. If, in the meantime, a lending bank’s dollar deposits moved to another institution, the lending bank would seek to reacquire dollars by borrowing them from other banks in the London interbank market.

This system created significant interest-rate risk for lending banks. So to protect themselves from rate fluctuations, they would charge Eurodollar borrowers a percentage above theinterbank rate commensurate with the borrower’s credit standing. In 1970, for instance, the electronics company Philips arranged a $250 million loan at 0.75 percent over LIBOR, while in 1975 the Soviet Union borrowed $300 million at 1.25 percent over. To handle loans of such size, banks formed syndicates to spread the risk; the Philips deal involved a group of more than 50 banks.

At the time, however, there was no uniform index for determining the true interbank rate, or reference rate, for these loans -- the function LIBOR is now meant to serve.

Banks involved in syndicated loans could expect to borrow in the market at slightly different rates. For each loan, then, reference banks that were deemed representative of a cross section of the syndicate -- or, for more neutrality, banks outside the syndicate -- were chosen by the parties. The rates at which these reference banks could borrow would be aggregated to form the “interbank rate” for the purpose of the loan.

This method was cumbersome, and offered multiple opportunities for manipulation. This was especially true in London, where an older banking culture of gentlemanly capitalism prevailed, and where favours and family connections were still central to a bank’s success.

First, large banks could increase their yields by bringing smaller, slightly less creditworthy firms into a loan syndicate, raising the reference rate for the group as a whole, while the large bank’s borrowing costs remained low.

More worrisome were gentlemen’s agreements intended to squeeze a few extra basis points from the quoted LIBOR. This method was described by the Financial Times in 1974: “whereby Bank A agrees to quote a slightly above realistic LIBOR for the purposes of fixing the rate payable by a customer of Bank B -- on the understanding that Bank B will do the same for Bank A when the time comes.”

In the context of London’s banking culture, such arrangements were accepted practice -- keep calm and carry on.