Libor scandal shows many flaws in rate setting

It is an open secret in the banking world: the interest rates for many mortgages and loans are based on a benchmark that is largely guesswork.

The flaws in the rate-setting process, which is used to determine the pricing for trillions of dollars of financial products, have been exposed by the latest banking scandal. Regulators around the world are investigating whether big banks gamed the rates for their own benefit before and after the financial crisis. But even if banks do not deliberately manipulate the rates, the benchmark remains vulnerable.

Banks derive the rates from estimates rather than real market data. So the benchmark, a measure of how much banks charge each other for loans, does not necessarily represent actual borrowing costs.

This weakness has only been exacerbated in recent years, as banks have mostly stopped lending to each other. Federal Reserve Chairman Ben S Bernanke told Congress he did not have “full confidence” in the process, calling it “structurally flawed.”

The troubles centre on a key benchmark known as the London interbank offered rate, or Libor. This rate and its variants are used to determine the prices for mortgages and other loans, and play a critical role in the multitrillion dollar market for financial contracts called derivatives.

The Libors are set every weekday around 11 am, a process overseen by the British Bankers’ Association. At that time, a group of big banks report how much interest they would pay to borrow money from other institutions over different periods and in different currencies. After removing the outliers, the remaining numbers are averaged to come up with the various rates. Recently, the three-month Libor, in American dollars, stood at 0.4531 per cent.

But the precise rates have little basis in reality. Since the crisis, many banks have been content to park their cash with central banks, rather than lending it out to other institutions. That means there are few interbank transactions on which to base their Libors, according to bankers who operate in this market.

“Libor was intended for an international lending market that has long since past,” said Pete Hahn, a finance professor at the Cass Business School in London. “The whole concept of interbank lending died after Lehman Brothers collapsed.”

Now, regulators and investors are questioning whether the benchmark should play any role in determining borrowing costs. Top central bankers will meet in September to discuss potential reforms.

The benchmark was supposed to solve a problem for bankers. For years, institutions haggled over the rates charged for different types of loans. To create consistency, the British Bankers’ Association developed the Libor standard. At the time, the interbank market functioned relatively well.

As the financial sector ballooned in the last two decades, Libor became increasingly more important. The rates currently cover 10 different currencies, and underpin more than $360 trillion of financial products worldwide. Even so, the process remains unregulated, with oversight falling largely to the bankers’ association. In response to concerns during the crisis, the association conducted a review of Libor and put changes in place in late 2008.

A spokesman for the trade body declined to comment. After Barclays agreed to pay $450 million to settle a rate-manipulation case with authorities in June, the trade organisation began its own investigation into Libor.

The British Bankers’ Association is also assessing ways to improve the process, along with central bankers and other authorities. But it is very difficult to improve Libor if a robust market does not exist.

The industry does not track comprehensive totals for interbank loans. One measure, published by the US Fed , shows that such lending has declined to levels not seen since the 1970s, although the figures do not capture the entire market.

Bankers indicate that such lending has almost completely evaporated. In the current environment, financial institutions will lend money to each other only for a short time, say one month or less.

That means banks are largely making estimates for key benchmarks like the three-month and the one-year Libor. Those two borrowing periods are critical. Vast amounts of derivatives are pinned to the three-month Libor, while the rates on many adjustable-rate mortgages are based on the one-year Libor.

Since interbank lending has stagnated, institutions are largely looking to other types of borrowing to come up with Libors, including certificates of deposits and loans from money market funds. But this is an inexact science that can distort the Libor market. There can also be wide discrepancies among similar benchmarks, which may reflect the artificial nature of the process.

During periods of turmoil, the process gets murkier. Some traders indicate that banks at times of stress report rates that would be almost impossible to achieve. At times, the flaws with Libor make it a convenient tool for Wall Street. If banks had to carefully reference a real, sometimes volatile, market, they might find it harder to set rates regularly. Allowing banks to submit guesstimates makes it  simple to come up with a daily number.

As the Libor scandal has unfolded, the industry is grappling with how to fix the process. One suggestion is to choose banks’ Libor submissions randomly when setting the overall rate, making it harder to manipulate.

Authorities have also proposed having independent auditors oversee the process. The race to replace Libor has also heated up. One suggestion is to use rates from another market that banks frequently use to lend to each other.

The Wall Street firm Cantor Fitzgerald is also developing an index of different short-term lending markets.