LIBOR is an average of the rates at which banks report that they are borrowing from one another each day, and it determines the rates for some $360 trillion-worth of other financial transactions, from mortgages to complex derivatives. During the financial crisis, bankers began lying en masse about the rates at which they could borrow money, and the rate became unreliable. Since then, central banks have brought lending rates back down, perhaps too forcefully. But banks have to find some benchmark upon which to base their loans, and coming up with a new or improved one will be difficult.
1. Any financial benchmark requires a delicate balance of opacity and transparency. How the benchmark rate is calculated must be opaque enough to disguise the real rate at which any given bank lends to another, to shield them from speculators. But it must be transparent enough not to be abused as LIBOR was.
LIBOR was also somewhat too transparent. During the financial crisis, Barclay’s borrowing costs spiked; had it reported the true rates it was getting to Thomson Reuters, which calculates LIBOR, investors would have sold its shares. It lied to protect itself. But in another sense LIBOR was too opaque. British regulators found that employees at Barclays tried (though in most cases failed) to manipulate the rate for marginal profits on specific contracts. An accurate rate would need to better shield banks from market angst during moments of financial stress, while being transparent to prevent any one bank or trader from manipulating the system for financial gain.
2. Hundreds of trillions of dollars in contracts are still denominated in LIBOR. Investors made bets on LIBOR years ago that extend far into the future. Until these trillions of dollars of contracts expire, bankers will need a means of settling them. Therefore, bankers will either still have to calculate LIBOR, or transfer contracts from an old system to a new one. Problematically, the financial crisis has destroyed lending between banks for any significant period of time, making the rate pretty much useless at many maturities. It is difficult for traders to calculate the price of a kind of long-term lending practice that no longer exists.
3. Central banks will have to give up control… The US financial crisis and euro crisis caused private lending rates to shoot up, so central banks stepped in to lend private banks money at low rates. LIBOR now reflects those low rates, so it is all but useless as an indicator of the true financial stress between banks. In reality, private banks are still wary of lending to one another, and a replacement rate will need to be made to reflect that. ”I think [loans should be issued at] whatever banks think their rates should be, whatever they think the market can handle,” explains Jerry Markham of Florida International University College of Law, the author of the authoritative A Financial History of the United States.
4. …or get rid of LIBOR altogether. Companies don’t in fact care at what rate the banks they borrow from fund themselves. Indeed, except in moments of severe financial stress, the LIBOR rate (denominated in dollars) tracks the US federal funds rate closely. Hypothetically, banks could just charge lenders a premium above the federal funds rate to borrow, and develop entirely separate securities and indicators to manage the complex derivatives that LIBOR was created to handle.
Perhaps most importantly, say some analysts, the LIBOR scandal and the financial crisis have triggered a media frenzy that makes it harder for banks and regulators to create an alternative. Indeed, too many people seem to forget the primary purpose of the rate—to measure interbank lending stress—in their post-crisis anti-banking hysteria. LIBOR was one of the main indicators analysts watched during the escalation of the financial crisis, so every little jump in the benchmark sparks a bout of doom-mongering. Markham concludes, “I think they’re putting way too much weight on LIBOR.”