Finger in the air

Sometimes, the world of finance is based on guesswork. Investigations into the alleged manipulation of the London interbank offered rate — known as Libor — have laid bare a flaw in the benchmark interest rate: banks can essentially make it up. That’s unsettling, since their submissions help shape the value of some $360 trillion of loans and derivatives. A better approach would be to base Libor on real transactions.

A Libor reality check requires a fundamental overhaul. At the moment, participating banks each day quote the rate at which they think they would be able to borrow from other banks in a variety of currencies for different time periods. The submissions are collected by Thomson Reuters, which lops off those in the top and bottom quartiles and averages the rest, while also disclosing individual submissions.

The crisis exposed several problems with this approach. When the interbank market dried up in 2008, banks quoted rates even though there was little actual lending taking place. Some banks may have quoted artificially low rates for fear of signalling their problems. Most damagingly, regulators are investigating allegations that traders colluded to manipulate Libor to their advantage. The best way to deal with these objections would be for banks to report an average of actual transactions rather than theoretical rates. However, this would have some drawbacks. First, banks aren’t always borrowing in, say, Swedish krona for eight months. For individual banks, absence from the process could be viewed as a sign of weakness. And if the market truly froze, rates could disappear entirely.

But these problems could be overcome if banks and the British Bankers’ Association — which oversees the process — established protocols on minimum volumes. They could also slim the Libor menu down to its most liquid currencies and maturities. Concerns over excessive transparency would be eased by publishing the average rate and the number of banks participating, but not individual submissions. In the event of a Lehman-style freeze, the BBA could either keep Libor rates at their previous day’s settings, or use estimates — with full disclosure.

Basing Libor on reality would make the benchmark more volatile, and therefore less useful. Yet there is no requirement for borrowers to base rates on Libor, and there are already signs that other benchmarks, like an overnight index swap based on secured lending rates, are gaining popularity. However, it could take years before any other rate rivals Libor’s dominance in financial markets. Though reforming Libor won’t be quick or easy, taking the guesswork out of the rate would be a good place to start.