Essay: Critical Evaluation of LIBOR Reforms

Introduction
LIBOR is a benchmark rate, that represents the interest rate at which banks offer to lend funds to other banking institutes in the international interbank market, for short-term unsecured loans (Investopedia, 2018) . This interest-rate is determined by a panel of sixteen major banks (i.e. Barclays, JP Morgan Chase), who provide estimated rates in various currencies and maturities, on their own interbank lending costs. Based on their major involvement in the London Market and their minimal credit risk, a selection process is held annually, to be considered eligible to determine these rates (Investopedia, 2018). Ultimately, the estimates provided from each bank reflects their perception of the financial health of opposing major banking rivals. Banks submit their individual rates daily to the British Bankers Association (BBA), to provide an average of the eight middle quotes, excluding the highest and lowest quartiles. This process obtains the LIBOR rate. LIBOR has sister-equivalent rates such as the EURIBOR, that also serves as a crucial benchmark reference across all financial markets, based on the strength of the Banking Sector.
LIBOR has huge importance worldwide, with its use in an array of financial products: ranging from futures/options to mortgages and student loans. Among them, Market participants have chosen to use the LIBOR for contracts having a notional value of more than $300 trillion and possibly much more (Abrantes-Metz, 2012). Furthermore, these rates aide the decision making of interest rates imposed by Central Banks, as the rates illustrate market behaviour expectations. LIBORs major importance in global finance and the lives of individuals, indicates how vital it is for these LIBOR rates to be accurately correct… However, by 2012, LIBOR took centre stage around the world as the “biggest financial scandal” in world history. Various banking institutes were accused and fined for manipulating the LIBOR. To date, various changes have occurred to the LIBOR after the scandal. Regulators in the United States, the UK, and the European Union have fined banks more than $9 billion for rigging Libor (McBride, 2016), including Big Bracket Banks such as UBS, JP Morgan Chase, RBS and ICAP.
This essay will review the extent of the LIBOR Scandal: how and why banking institutes manipulated these rates to; and to critically evaluate the impact of reforms/reform proposals to prevent similar manipulations.
How and Why did Banks Manipulate LIBOR?
Numerous amounts of Investments worldwide are attached to LIBOR. When the Value of LIBOR depreciates, it indicates that Banks have faith in other rivals. When the Value is High, there is widespread instability between Banks. These fluctuations in the value of LIBOR proved vital in assisting different types of manipulations that had occurred between banks.
There were two types of manipulations in the LIBOR Scandal. On one hand, this insidious corruption occurred in-house, between a variety of traders within the firm. Swaps traders often asked the Barclays employees who submit the rates to provide figures that would benefit the traders, instead of submitting the rates the bank would actually pay to borrow money (New York Times, 2012). On the other hand, manipulations occurred between other counterparties – where external traders across different banking institutes would cooperate to fix the LIBOR.
Ultimately, Traders at these top Banking firms were conspiring to distort the LIBOR rates because of their excitement in enduring elevated profits. Traders would capitalise off these manipulations by marking their positions on the spread between different LIBOR Benchmarks, in numerous time frames (Liam Vaughan, 2017). For example, the three-month Euro and the three-month EURIBOR or comparing the three-month TIBOR to a six-month TIBOR. They would also exploit different trading positions and submissions that other companies would make. Banks like Barclays followed suite of the LIBOR distortion. They submitted falsified data after the 2007-08 Financial Crisis, by deflating (having lower) borrowing costs compared to their actual value. Not only did this occur because banks wanted to avoid revealing their financial instability to the world, but they also aimed to protect themselves, during and after a time of major financial crisis. As LIBOR became easy to manipulate, banks had the incentive to alter their data because of the fear of losing out on positions worth trillions of pounds. However, this implies the senior management of these banks were aware of LIBOR rigging, as they were the most knowledgeable on the firm’s market position. This is implicated through the resignation of Banking leaders involved in collusion, including Former Barclays Chief Executive, Bob Diamond.
Proof that these manipulations were occurring was evident through a humiliating bundle of emails and conversations between Bank Staff, released by UK and US Regulators. On 26 October 2006, an external trader made a request for a lower three-month US dollar LIBOR submission – The external trader stated in an email to Trader G at Barclays “If it comes in unchanged I’m a dead man”, which Trader G responded that he would “have a chat” (Telegraph, 2012). As a result, the three-month US LIBOR was reduced that day, as requested by the external trader. Such emails and messages illustrate how traders explicitly inform submitters and other traders to alter the data, for the benefit of their own and the bank.
LIBOR was also manipulated because there was no regulatory pressure or any form of governmental intervention from lawmakers or the Central Banks. As LIBOR being determined by a selection of highly rated banks, the ease of LIBOR manipulation was due to restrictions not being imposed by governments. However, it can be argued that the Government’s and Central Banks, such as the Bank of England and the Federal Reserve, were aware of this manipulation. A New York Fed spokesperson said in a statement that “in the context of our market monitoring following the onset of the financial crisis in late 2007, involving thousands of calls and emails with market participants over a period of many months, we received occasional anecdotal reports from Barclays of problems with Libor (Huffington Post, 2012) . This illustrates that the Federal Bank were aware of the flaw but didn’t take appropriate action towards LIBOR Concerns. Moreover, I believe they did not react for the hope of an economic resurgence. As the financial crash resulted in low “self-esteem” market, The LIBOR value deprecating would nullify this depression and restore the global economy. This benefited Governments around the world, as an impression of alleviating financial markets from disarray, which boosts public confidence in the marketplace.
Despite this, the fluctuation of LIBOR had a massive effect on businesses, investors and ordinary individuals. LIBOR increased proportionately with an increase in the cost of borrowing. The consequences of increasing borrowing costs were passed onto consumers by increasing debt and mortgages. However, investors benefit as savings increase. LIBOR decreasing correlated with a decrease in savings, whilst showing good signs for mortgage holders. Although, individuals believe a decrease in interest rate means paying less on consumer contracts, such as mortgages and credit cards – this contrasted with the occurrence of interest swaps and LIBOR fluctuating both upwards and downwards. Overall, ordinary individuals suffered as the Local Government would lose more money. Services that people benefit from, such as schools, hospitals, fire departments and public services, have placed their money in adjustable rate mortgages, currencies, mutual funds, pensions and derivatives (MGA, 2012). Manipulating the rates has resulted in Banks not pumping profits into these financial instruments. And poorer people with bad credit profiles are disproportionately affected. In Ohio, for example, 90 percent of all subprime mortgages in 2008 were indexed to Libor, double the proportion for prime loans (Liam Vaughan, 2017). Traders on the other end of the transaction also lose out. As Banks collude with each other, it is evitable that some Bank reaps the reward of capitalizing on the manipulation, whilst the other banks and traders must fall victim for the meantime. Due to the vast importance of LIBOR, a tiny manipulation in the wrong direction could result in trillions of pounds being lost.
Critical Evaluation of LIBOR Reforms
Wheatley’s proposal on reform recommendations have been implemented since and have proved successful in maintaining and preventing future manipulation in LIBOR. One of his recommendation’s including the ratification of replacing the British Banking Association as the LIBOR administrator, with the ICE Benchmark Administration (IBA).
Wheatley insisted that banks should submit actual transactions, rather than ‘expert’ estimations on the rate. Five less frequently traded currencies have also been discontinued (NZD, DKK, SEK, AUD, CAD), while the five that remain now only report the 1 day, 1 week, as well as the 1, 2, 3, 6, and 12-month maturities (David Hou, 2014). Publishing submissions based on transactions is very important. During the Scandal, submissions from banks would occur on the same day. Given this reform and changing submission of publication from immediately to one months after, this heavily restricts various banks from distorting numbers for the benefit of their own. This provides a more accurately, consistent rate at which banks lend at, which will benchmark the rate more to its true value.
The Financial Conduct Authority (FCA) now overlooks the regulatory procedures of LIBOR, which their conduct is centred around Wheatley review: where falsifying submissions is now a criminal offence, and can result to heavy, harsh fines and prosecutions. This regulatory pressure aides the suppression of Banks, and acts as a deterrent for further manipulations. Now, Banks take precautionary measures when submitting data, given the harsh actions that would unfold if they didn’t comply. Recently, in 2016, The Chief Executive of The FCA concluded to bury LIBOR, due to producing far below average transactions of currency-tenor in year 2016.
The FCA are aiming to reform the LIBOR by phasing out LIBOR after 2021 – meaning Banks no longer need to conform to the submission of data by regulators. Following the financial crisis, banks have shifted away from unsecured short-term borrowing, preferring repos, bonds and other forms of financing (Paul Cantwell, 2018). So these factors coupled with LIBOR’s unsustainable structure in the money markets, and Banks willingness to maintain investor and consumer trust, will result more banks voluntarily retracting from LIBOR Submissions in the future. Although, I believe this process will be a success, it will prove to be a very difficult transition to completely phase out a widely used rate. There are still trillions of pounds worth of financial instruments that are pegged to LIBOR, and in some cases, still have maturities after 2021. LIBOR is still a floating rate for a huge sum of contracts, regardless of alternative risk-free rates.
Alternative risk-free rates have been proposed and soon to be implemented by regulators all around the world. Over time, regulators hope that more derivatives and loans will be backed by the rate, which will decrease the importance of Libor (Reuters, 2018). Various countries have adopted their own risk-free rates such as: SONIA (UK), SOFR (US) and more.
These rates are set in overnight markets. The LIBOR had maturity ranging from a variety of different periods, such as the three-month LIBOR. These new rates are determined once, at the end of each period. So, Unlike LIBOR, banks are unable to know how much interest rate is to be paid until the end of that overnight period, implying the disparities in payment between both these rates and LIBOR rates respectively. This model could prove advantageous in preventing collusion between banks, but these new rates adapting to market conditions and everyday life can have major implications. These complications include indexing and hedging these risk-free rates to LIBOR rates in various currencies, to link products to the new rate. What risk management instruments are needed to retain liquidity? The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design and hedging strategies (Paul Cantwell, 2018). Such complications to a new model imposes further costs and uncertainty in adopting these rates appropriately. Moreover, these issues are dragged across to company stakeholders. For example, Members of staff are subject to a change in operational procedures, as they will be given training on how to work with new accountancy and tax processes, and how to endure systematic changes. These factors cause major concern.
Unlike the SONIA, which is used in the UK to reference the OIS, other alternative rates such as the US SOFR are secured, rather than unsecured. These secured contracts eliminate credit risk, which provides lower interest rates than unsecured rates. This gives a variety of options, such as cross-diversifying financial and retail contracts in different countries, to spread risk.
In Conclusion, the world’s largest banking cartel has given a huge insight into how the major banking players can manipulate numbers through collaboration and in turn, discredit individuals to reap profits and for the protection of their own. Once the world’s most important number became implicated as Fraudulent, Regulators made Banks and Bankers aware of how destructible they were – by ensuing large fines, the ‘stepping down’ of senior banking officials and arresting Inside Traders for Criminal Offences. Wheatley’s review of recommendations and other reforms that were already implemented, has shown great effort and achievement in reforming the LIBOR. However, a great number of contracts and derivates are still attached to LIBOR, that could even last longer than the 2021 Date of LIBOR Expiration, which would cause a huge problem in years to come. Once implemented, these new reference rates are pressured to take on the huge responsibilities of contracts, due to LIBOR’s reducing structure. Furthermore, measures taken to do so seem very complicated