What went wrong with the LIBOR and EURIBOR?
The London Interbank Offered Rate (LIBOR) and the Euro Interbank Offered Rate (EURIBOR) are crucial to the global financial system because they act as a reference or benchmark for the rates pricing of derivative products which are traded in massive amounts (Royal Bank of Scotland, 2012). Additionally, they have a considerable influence on loans and mortgages for households and businesses, and many other contracts. This is because they are used to help price products from home loans to credit cards worth over $300 trillion across the globe (Reuters, 2013). Libor is administered by the BBA and used is throughout the world while Euribor is the eurozone equivalent.
Despite their strategic importance in the global economy, the economic consultative committee at the Bank for International Settlements in March 2013 suggested that these rates should be replaced with reference rates based on actual market transactions and suitable for different purposes (Wamique, 2013). This came in the wake of instances of market manipulation by rate-setters, which had increasingly raised concerns about the reliability of the processes and methodologies used to calculate the main reference interest rates.
Following investigations into the manipulation of the two benchmarks, several renowned financial institutions such as Barclays were prompted to pay hefty penalties in mid-2012 to put an end to the investigations by British and United States regulators. Barclays was fined for allegedly manipulating the rates to boost its earnings on derivative financial products. The fact that banks had the capacity to influence these reference rates implied that rates such as LIBOR were possibly lower than they should have been during the Credit Crunch.
Moreover, if banks other than Barclay’s also had the capacity to manipulate their quotations, the probability that reference rates were lower than they should have been was increased considerably because reference rate administrators such as the BBA more often than not ignore outliers in their calculations. Low reference rates translated to low interest rates, which in turn had a negative impact on borrowers with floating credit agreements. This is because the latter are in most cases accompanied by mandatory hedging contracts, which are meant to protect both borrowers and banks from extremely high and extremely low interest rates respectively. When prevailing interest rates are very low, borrowers are forced to pay higher rates on derivative contracts like interest rate swaps.
Other than manipulation, there was a sharp decline in market activity since the global financial crisis, which generally raised questions about the “robustness and usefulness” of reference interest rates based on term unsecured interbank markets, such as LIBOR, EURIBOR and TIBOR, especially in times of market stress (Wamique, 2013). The chairperson of the committee, Mervyn King, who is also the Governor for the Bank of England, argued that central banks should play a significant role in supporting the development of alternative and more effective reference rates. The committee however also pointed out that if the level of governance and administration of existing reference rates was unsatisfactory, central banks would have to work with the private sector to ensure these needs are met.
Given the importance of the aforementioned reference rates on the global economy, key stakeholders are charged with the responsibility of ensuring that they are efficient and reliable in order to facilitate market stability (Reuters, 2013). In this regard, shortly after the LIBOR scandal in June 2012, the managing director of the FSA and CEO-designate of the new Financial Conduct Authority (FCA), Martin Wheatley, was tasked by the Government to establish an independent review into various aspects of the setting and usage of LIBOR (Wheatley, 2012).
According to the Wheatley Report, because there were so many contracts that relied on LIBOR, the transition to a new reference rate generation mechanism needed to be as smooth as possible. Unfortunately, there was no mechanism of equal standing and quality in London to replace LIBOR so policy makers would be forced to repair the broken LIBOR. This would be achieved by reducing the number of LIBOR reference currencies to only those which have a real “market” where quoted rates could be identified, then having rate information collated by a government overseen independent body rather than the BBA (Ince, 2012). Quotations would however still be given by a panel of banks, which would nonetheless have to be with reference to actual transactions of that day, unless it was explicitly stated otherwise by the bank. New regulations would also have to be enacted to facilitate ethical practice among banks, which would call for a new Code of Conduct.
Notwithstanding, the EBF, which is responsible for administering the EURIBOR was of the opinion that their system collated information from local banking associations and would therefore be less likely to succumb to manipulation. Other critics including Gary Gensler, the 11th chairman of the Commodity Futures Trading Commission, the Undersecretary of the Treasury for domestic finance, and co-head of finance for Goldman Sachs, however pointed out that LIBOR was almost always quoted at half EURIBOR, which was a likely indicator that it was also being manipulated. This is illustrated in Appendix 1.
Mr. Gensler further argued that LIBOR should simply be scraped because the proposals in the Wheatley report could simply not suffice to address the challenge of manipulation (Reuters, 2013). This was evidenced by the fact that LIBOR rates were so much more stable than credit default swap prices on debt issued by the same banks, which were supposedly adhering to the new regulations, given the prevailing volatility at the time the report was released. This is illustrated in Appendix 2. Mr. Gensler argued that LIBOR and EURIBOR are unsustainable in the long run and suggested that the new reference rates should also include benchmarks linked to gold, oil and other commodities (Reuters, 2013).
To conclude, several stakeholders in the global financial sector lost faith in LIBOR and EIURIBOR as international reference rates because they had apparently been manipulated by some renowned financial institutions for several years. As a result of the manipulation, a number of key stakeholders argued that these mechanisms would no longer suffice to act as benchmarks for pricing derivative products and a myriad of other financial contracts because they threaten the stability of global financial markets.
Ince, I. (2012, October 1). LIBOR (and other mythical beasts). Retrieved March 3, 2015, from http://criticallegalthinking.com/2012/10/01/libor-and-other-mythical-beasts/
Reuters. (2013, April 22). Top Regulator Wants LIBOR, Euribor Scrapped. Reuters Hedgeworld.
Royal Bank of Scotland. (2012, July 4). Libor, Euribor: global finance’s tick-tock; Benchmark for derivative product pricing. National Post, p. FP.3.
Wamique, M. (2013, Mar 25). Central bankers call for plan to scrap LIBOR, EURIBOR. SNL Insurance Weekly Life & Health Edition.
Wheatley, M. (2012). The Wheatley Review of LIBOR: Final Report. London: Crown copyright.
Appendix 1: Relationship between LIBOR and EURIBOR
Appendix 2: Volatility