Libor’s uncertain future

Libor is in a spot of trouble. The economic indicator, which stands for London Interbank Offered Rate, is widely watched as a measure of credit risk in the economy. But it has also been the subject of investigations by regulators in the United States, Japan, the United Kingdom, and the European Union. Libor is supposed to be free from abuse, but the investigations suggest otherwise.

First introduced in 1985 by the British Bankers’ Association, Libor influences rates on everything from credit cards to mortgages to financial products. Every morning, a panel of banks submit “bids” that detail the rate at which they feel they could borrow money in various currencies. What gets reported is the interquartile mean, or the average of the middle 50 percent of those bids.

The problem is that the process of submitting those bids is not entirely transparent. Since many financial instruments are tied to Libor, traders at some banks apparently tried to influence the indicator by misreporting their bids to boost their profits.

“Libor is a standard reference rate used to construct and settle trillions of dollars worth of contracts annually,” said Robert McDonald, a professor of finance. “Manipulation of the rate is an embarrassment for the banks and the regulators, will undoubtedly lead to lawsuits, and undermines the integrity of the financial system.”

As such, the BBA is considering changing the way Libor is calculated to avoid similar problems in the future. They say it is part of a regular review of the indicator, but the scandal undoubtedly has something to do with it.

The overhaul is something of a tacit admission that Libor is manipulable, something which BBA has previously denied. Despite that, McDonald says the rethink won’t hurt the measure any more than the scandal already has.

A future without Libor is difficult to imagine. According to a government bond trader interviewed by the Financial Times, “If you want a figure for term interbank rates, you have to use the Libor survey because there are no or very few actual trades.”

Still, if Libor does fall out of favor, McDonald is certain something will take its place. “People would latch onto or construct something,” he said. What’s less certain is what that something will be.