London fog: Banks behind Libor benchmark come under increased scrutiny

December 1, 2011

Every workday morning in London, at about 10 o’clock, representatives from 19 banks make a series of decisions that affect financial transactions around the world, from what homeowners pay on their mortgages to the underlying value of credit default swaps and corporate bonds.

The bankers’ power is unsettling, says Tim Price, who helps oversee more than $1.5 billion as director of investment at PFP, an asset management firm.

“It’s a kind of Wizard of Oz surrealist nightmare,” he says.

It could hardly be more real. What the bankers are deciding on is Libor, the London interbank offered rate. Libor is based on what each participating bank says it would have to pay to borrow money from another bank.

The rate, produced under the auspices of the century-old British Bankers’ Association, represents the average of the collected figures, minus several of the highest and lowest quotes.

The resulting benchmark determines interest rates on an estimated $360 trillion of financial instruments around the world, according to the Bank for International Settlements.

Unelected and lightly regulated, the Libor panelists have come under increasing scrutiny from money managers such as Price who say Libor is biased in favor of the bankers who submit the quotes.

“The whole system is rigged,” Price says. “The banks are able to say, ‘Let’s just collude and set rates, and we have the sanction of the authorities to do it.’ ”

Market manipulation

In a series of lawsuits filed in 2011 and now winding their way through courts in Europe and the United States, investors have accused a number of banks represented on the Libor panel of distorting market prices by hiding the banks’ true borrowing costs since as early as 2007.

In August, Charles Schwab, a brokerage firm and investment manager, sued 11 major banks, including Bank of America, Citigroup and J.P. Morgan Chase, claiming they conspired to manipulate Libor, depriving investors of fair returns.

The banks conspired to depress Libor by understating their borrowing costs, thereby lowering their interest expenses on products tied to the rates, according to the lawsuit. The banks “reaped hundreds of millions, if not billions, of dollars in ill-gotten gains,” Charles Schwab said.

Danielle Romero-Apsilos, a spokeswoman for New York-based Citigroup, said, “We believe the suit is without merit.”

In addition, regulators and prosecutors in the European Union, Japan, Britain and the United States have been investigating whether banks manipulated Libor to conceal the extent of their financial distress from lenders and shareholders.

The Edinburgh-based Royal Bank of Scotland disclosed in August, for example, that it had received requests for documents from E.U. and U.S. regulators.

Barclays, Credit Suisse Group, HSBC, Bank of America, J.P. Morgan Chase and RBS all declined to comment about the lawsuits and inquiries in which they were defendants or targets.

Misgivings about Libor have been gathering momentum since the early days of the financial crisis in 2008. Analysis of Libor over time shows that the spread between low and high rates submitted by bank panelists widens most at times of greatest financial distress.

Widening spreads

That was the case in the immediate aftermath of the Sept. 15, 2008, collapse of Lehman Brothers, when the difference in the rates submitted by Libor panelists on three-month loans in dollars increased from seven basis points to 115 basis points by the end of the month. (A basis point is one-hundredth of a percentage point.)

It was also the case more recently as the European sovereign-debt crisis deepened and concerns mounted about banks exposed to economically fragile debtor nations such as Greece and Italy.

In November, the spread between the lowest and highest rates being submitted for three-month dollar loans was at its widest in more than two years.

The difference reached 30 basis points Nov. 8, with Credit Agricole saying it could pay 0.575 percent to borrow funds while HSBC said it could pay just 0.275 percent. The Nov. 8 spread was the widest since market volatility in May 2009.

While the BBA says it’s willing to consider changes to Libor, its response to criticism has been muted. Days before Lehman’s bankruptcy, BBA chief executive Angela Knight said it was moving at a “good, steady pace” to improve the scrutiny of the rate-setting process.

In March, the BBA said, “We are committed to retaining the reputation and integrity of BBA Libor, which continues to be the authoritative benchmark of the wholesale money market.”

Libor, inaugurated in 1986, arose out of a need for a dollar rate to be set outside the United States, says Christopher Wheeler, a banking analyst in London. In the 1970s, London was growing as a center for financial transactions. That was partly because, during the oil crises, Arab and Soviet producers were looking to park proceeds from their dollar-denominated sales of crude with London banks to shelter revenue from U.S. authorities.

Several early versions of benchmark rates evolved into BBA Libor, set in dollars and pounds, in 1986. The birth of Libor coincided with then-British Prime Minister Margaret Thatcher’s Big Bang financial deregulation program and the consequent growth of bond and syndicated-loan markets in London. Thomson Reuters, which competes with Bloomberg in selling financial and legal information and trading systems, calculates the rate.

While the suite of currencies has since expanded to 10 and the collection process is electronic, Libor has changed little in the past quarter-century.

The banking industry, on the other hand, has been transformed by the proliferation of new financial instruments and by the vanishing separation between commercial and investment banks.

In March 2008, after the subprime mess spread beyond the United States, the Bank for International Settlements, known as the central bank for central bankers, questioned the accuracy of Libor quotes.

Threat of expulsion

“If there is uncertainty about the liquidity position of a contributing bank, the bank will be wary of revealing any information that might add to this uncertainty for fear of increasing its borrowing costs,” the BIS said. “Banks’ quotes are determined by strategic behavior as well as credit quality and funding needs.”

Responding to such criticism, the BBA decided in June 2008 to review the system for setting Libor. It subsequently increased the number of banks on the dollar Libor panel to 20 from 16.

The BBA also added three non-contributing members to the Foreign Exchange and Money Markets Committee, the independent group that oversees Libor. And the BBA said it would expel any firm that was found to be deliberately misstating its borrowing costs.

The attacks on Libor continued unabated. The British Financial Services Authority, the U.S. Commodity Futures Trading Commission, Justice Department, Federal Trade Commission and the SEC have all launched investigations.

“The complaints are substantially similar and allege, through various means, that certain members of RBS Group and other panel banks individually and collectively violated U.S. commodities and antitrust laws and state common law by manipulating Libor and prices of Libor-based derivatives in various markets,” RBS said in August.

In April, a European asset management firm and two funds accused 12 banks, including Bank of America, Barclays, Citigroup, Credit Suisse, HSBC and J.P. Morgan Chase, of conspiring to manipulate Libor. FTC Capital of Vienna, FTC Futures Fund PCC of Gibraltar and FTC Futures Fund SICAV of Luxembourg alleged in U.S. District Court that the banks had distorted the value of futures contracts used by traders and investors to speculate on the direction of interest rates.

“My client’s trading of euro-dollar futures was harmed as Libor was not fairly priced,” says David Kovel, who represents FTC Capital. Kovel didn’t identify specific trades that resulted in losses, nor did he reveal how much FTC Capital is seeking from the banks.

Marco Bianchetti, who holds a PhD in theoretical condensed-matter physics from the University of Milan and works on the market risk management team at Intesa Sanpaolo, says quantitative analysts who engineer financial transactions need a reliable benchmark.

He says a rate based on transactions would be more trustworthy than Libor. British Debt Management Office chief executive Robert Stheeman agrees. While he says he doesn’t question the integrity of Libor, Stheeman says he’s concerned about its authority as a benchmark.

“That, to me, is the real issue,” he says.

In that spirit, the search is on for Libor alternatives. In Britain in June, the Wholesale Markets Brokers’ Association launched a reference rate called the Repurchase overnight index average, or Ronia. It’s based on actual money-market deals struck from noon to 4:15 p.m. London time.

Roberto Verrillo, a managing director of British interest-rate products at Nomura International in London, helped to develop Ronia. He says Ronia’s advantage over Libor is that it’s based on real deals.

As influential as Libor is today in determining interest rates around the world, Peter Hahn, a professor of finance at Cass Business School in London and a former managing director at Citigroup, says its authority may slowly ebb away.

“As it becomes less relevant, it becomes even more unreliable,” Hahn says. “It’s up to the market to come up with alternatives that have a lot more integrity and aren’t as influenced by the conflicted interests of their participants. The battle is on for a new, more credible alternative to Libor.”

The full version of this Bloomberg Markets article appears in the January edition.

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