Candidates to Replace Libor Are Lackluster

In a paper released in connection with the British government's review of the London interbank offered rate, Martin Wheatley, managing director of the U.K.'s Financial Services Authority, identifies a number of significant weaknesses that have eroded the credibility of Libor as a benchmark. FSA is likely to use these findings to recommend a number of immediate changes to the Libor regime.

Wheatley's review says the volume of unsecured interbank funding has diminished significantly in recent years due to the reduced credit rating of banks post-financial crisis and new regulatory capital requirements (Basel III). Additionally, banks increasingly have financed themselves with more secured financing (e.g. repo market financing), central bank liquidity and long-term debt. With fewer transactions to base their Libor rate submissions on, banks have become increasingly reliant on "expert judgment," and because there are no mandatory criteria required to be taken into account in the exercise of this judgment, banks have more or less a clean slate upon which to base submissions. Wheatley also notes there is no transparency in the process – banks do not have to disclose the details of how they derived their Libor rate submissions. In addition, those exercising the judgment – the 24 banks on the Libor panels – are not disinterested in the outcome of the process, as the rates they submit signal the bank's perceived creditworthiness and will affect trading and lending positions. Lastly, Wheatley states the process has been essentially self-policed and that policing is not always vigorous.

Wheatley will likely recommend that oversight and regulation of the Libor regime be vested in an international organization (such as the International Organization of Securities Commissions or the Financial Stability Board) whose determinations would be implemented by national regulators such as the FSA and the U.S. Securities and Exchange Commission or Commodity Futures Trading Commission. This regulatory body promulgate would express a hierarchy of criteria that banks would utilize in making Libor submissions to the extent the submissions do not rely exclusively on actual interbank borrowing transactions. Criteria might include a bank's commercial paper borrowing rate, rates implied by its credit default swaps, its unsecured overnight borrowing rates or its repo rates. The banks could be required to disclose the details of the criteria their rate submissions are based on and make a consequence-bearing affirmation that the submission was made in good faith and the description of the criteria it was based upon is sound. Lastly, Wheatley may recommend the number of panel banks be significantly increased from 24 and each currency panel size be increased accordingly.

Long term, Wheatley may recommend the role of the submitting banks be limited to that of data input providers, rather than those who exercise the judgment as to what borrowing rates for their bank would be absent of clear actual transaction data points. This could be filled by a new player with appropriate expertise and market knowledge, but without the conflict of interest. In this type of regime, banks would provide to the entity exercising judgment specific transaction information regarding interbank borrowing, commercial paper, credit default swaps, overnight borrowing, repo transactions and other relevant transactions. That entity would use the promulgated criteria to calculate the Libor rates. Bloomberg LP has already expressed interest in performing such a role.

What is most clear from Wheatley's paper is that each of the possible replacements for Libor as the benchmark rate has its own issues. For example, the central bank policy rates and overnight unsecured borrowing rates lack the critical maturity curve; commercial paper rates have transaction volume and distressed market resilience issues and overnight index swaps, Treasury bills and repo rates exclude meaningful counterparty risk. None of these options would be immune from potential manipulation.

There is tremendous market benefit to interest rate benchmarks that are simultaneously published daily for multiple currencies and maturities – Libor did not gain its global acceptance by accident or by fiat. Any migration away from Libor as the principal interest rate benchmark will need to be market driven and, even in the face of the current scandal, the Libor benchmarks continue to serve their function. With recommendations due in early September, the remainder of Wheatley's summer will be figuring how best to extract the baby from the bathwater.

Richard E. Farley is a partner in the leveraged finance group of Paul Hastings LP and represents many of the banks currently included on Libor panels.