The behavior of the London Interbank Offered Rate in the market during the financial crisis Essay

Executive Summary

The report is an attempt to firstly explain the process through which BBA goes through everyday to come up with Libor rates in 10 different currencies and 15 different maturities. These 150 rates are published everyday just after 11.am London time on every business day. The important thing with Libor is that it is the basis for more than $350 trillion worth of contracts worldwide. Banks, financial institutions and other firms use Libor as their prime benchmark for pricing swaps, loan syndicates and other banking products. Another important consideration here is that Libor is a critical barometer in recent times for gauging credit crunch and other financial woes that might impact world markets.

In recent months Libor has come under heavy criticism especially from US experts and commentators as an inefficient measure that does not accurately predict the borrowing cost of funds that are unsecured in the interbank market. The criticism is mostly toward the Libor’s inability to reflect the American banking industry on its 3-month US Libor. Secondly a figure is pointed toward banks who set the minimum rate it takes for them to borrow funds; critics argue that these banks deliberately keep rates low to overstate their credit worthiness.

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This report has suggested certain measures that could be taken to overcome certain anomalies of the Libor rates. The report suggests that certain slight changes could radically improve the Libor. Firstly, the definition and the question that BBA asks banks should be made more quantitative; secondly more banks from the US should be included in the panel that is used to collect data. These measures will go a long way to not only improve the issues that Libor faces but also significantly impact the way markets work in a positive way.

Ultimately the Libor is a fundamental benchmark rate that has become extremely important to the functioning of the global financial markets therefore it is important for us to understand that just because a rare financial crisis we do not go about making unnecessary and hasty changes to a strong barometer. Certain changes are required to put more value to the benchmark but no more needs to be done than these changes for now. In our opinion we see a probable replacement of Libor a few years down the road but that would not be so unless the new set of regulations and principles are set across financial markets and economies. We also think that even if Libor is replaced it will continue to serve its purpose as an important indicator of major changes in the financial markets.

We also believe that the Treasury yield and Libor spread is an important indicator of liquidity and it also explains the confidence that banks have on each other when it comes to lending for the short-term.

Introduction: A Brief History of the Origins of LIBOR
During the early 1980s it became evident that major banks in London were interested and attracted towards new instruments which included Forward Rate Agreements, Interest Rate Swaps and the like; although these new arrangements provided banks with a new opportunity to earn but banks kept at bay from these instruments because they were worried about the rates at which banks had to agree on these contracts.  (British Bankers’ Association, 2010) As a result the BBA (British Bankers’ Association), that represented a major chunk of banks operating in London, was asked by banks in the region to come up with a measure or benchmark that could provide stability and a rate that could be used to settle future agreements.

The first BBA-LIBOR rates were published in January 1986 and these rates were initially for three major currencies: Japanese Yen, US Dollars, and Pound Sterling. Later on 7 more currencies were added to the work load with 15 different maturity periods. The only major change came out in 1998 when the question asked by the BBA from its pool of banks changed from “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?.” To the improved and newer version “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?.” Now that we have looked at the brief history of LIBOR we would look at what is the definition of BBA-LIBOR, how it is calculated and what factors play an important role when the BBA determines LIBOR rates. (BBA-LIBOR, 2010)

Defining LIBOR- The Basics
LIBOR is the abbreviated term for London Interbank Offered Rate. The term is also referred to as bbalibor since the BBA is responsible for its calculations. In a nutshell, LIBOR gives an idea as to how much it would cost, on average, to a leading bank, for a particular currency, to borrow unsecured funding for a particular time period in a seasonable sized market. The unique concept underlying LIBOR is the fact that banks are asked to report the offered rate rather than the bid rate. What this means is that LIBOR represents the lowest potential rate at which most large banks can lend money in London and around the world. (British Bankers’ Association, 2010)

The crucial thing here to note is that the rates quoted by banks on BBA’s panel are not actual rates for transactions; the reason for this is that if BBA makes it a compulsory requirement to have rates for all currencies for all different maturities than it will be impossible for banks to compile such data as not all banks deal with all the 10 currencies and 15 different time periods; however because banks are fully aware of credit ratings and creditworthiness therefore they can extrapolate or forecast rates of currencies and time periods for which they might not trade.

The concept of ‘reasonable market size’ is left open to debate or shall we say defined with grey areas; according to the BBA this has to be done because the current scenario is such that conditions and market factors are changing almost daily and therefore this side of the definition has to be scrutinized regularly. An important change that has come into the definition is the changing of the lead question that is asked from panel banks to collect the preliminary data for LIBOR calculations. The improved question that we have already stated above increases accountability and transparency of the whole LIBOR calculation process.

Another technical explanation is related to a market convention. All rates that are quoted within the daily LIBOR sheet are annualized interest rates. For example if the LIBOR rate for overnight sterling loans is 2.00001% than that means on average leading banks will have to pay 2.00001% divided by 365 multiplied by the sterling loan for an overnight borrowing transaction.

Calculation of LIBOR- From Bank Selection to Arithmetic Mean
The three guiding principles for selecting a contributor bank are a) its credit worthiness, b) expected expertise in the particular currency, and c) scale of market operations/activity. The contributor banks panel range between 8-16 banks for the 10 currencies. These banks are selected by the independent Foreign Exchange and Money Markets Committee (FX and MM Committee); the basic idea behind the selection process is to ensure that panel banks represent in the most accurate way possible the money market operations within London in that particular currency. We would also like to mention here that under the guidance of BBA the FX and MM Committee evaluates and reviews the contributor banks on an annual basis. The evaluation is based on the current market size and other two factors explained earlier. (BBA-LIBOR, 2010)

All the contributor/panel banks have to provide the set of rates for all the 10 currencies each morning between 11.00 am and 11.20 am local time (London); BBA’s official calculation agent is Thomson Reuters who receive all the rates from various panelist banks. Of course panelist banks cannot see each others rates. Once Reuters receives the data they run many simulations and tests on these data before they are sent for calculation. The calculation process is simple: all the rates from various panelist banks are produced in a particular order whereby the upper most quartile (top 25%) rates and lower most quartile (bottom 25%) rates are deleted from the calculation and the middle 50% or the middle two quartiles are used to calculate a simple arithmetic mean. These calculations are done for each of the 10 currencies for each of the 15 maturities henceforth for every business day BBA publishes 150 rates for financial markets worldwide. The reason for not including the outlier ranges or values is to ensure that no contributor/panelist can influence an important financial market indicator such as the LIBOR.  The currencies that are covered under bbalibor include: the Euro, US dollar, Pound Sterling, Japanese Yen, Swiss Franc, Canadian dollar, Australian Dollar, Danish Krone, New Zealand dollar, and Swedish Krona; the maturity period of these rates range from overnight to 12 months. (British Bankers’ Association, 2010)

Distinct Traits of LIBOR and its Role in Contemporary Financial Markets
The economic downturn especially in the developed economies coupled with the financial crisis led to one of the most difficult times for the major economies of the world. The worse part was that many economies suffered because of the mistakes committed by regulators, institutions and individuals elsewhere in the world. The twin crises also highlighted and reaffirmed that major world markets and economies are closely tied and events in one economy can impact the financial markets of another country or region. Secondly financial institutions such as banks, mortgage houses, investment houses, asset management companies, insurance companies, reinsurers and other financial institutions were far more intertwined in comparison to 1970s and early 80s.

This brief perspective on the global twin crises forms the basis of how important LIBOR is to the financial markets. Just like the key interest rate set by a particular central bank reflects the policy that is being pursued by that government, whether expansionary or contractionary monetary policy, similarly LIBOR is a controlled estimate by leading banks as to how much it would cost them to borrow unsecured funds from their peers. Recent research shows that some $350 trillion worth of swaps are indexed to LIBOR and around $10 trillion worth of loans are related to LIBOR. The bbalibor is used by major futures and options exchanges of the world to settle interest rates and related contracts. Increasingly, LIBOR is also used to cost and price retail products such as home-mortgages and student loans. (BBA-LIBOR, 2010)

Primary Objectives of the Research Paper
The main objective of this research is to determine the limitations of the London Interbank Offered Rate (LIBOR). There are several elements which influence LIBOR hence these factors play an important role in determining its peak. This study will focus primarily on factors that affect the LIBOR as well as attempt to outline ways of improving it, especially in forecasting a looming financial crisis. We would also look at potential alternatives to the LIBOR and explore the option of developing a new barometer for various regions of the world rather than depending on a single indicator.

Segregation of the Report into Main Topics and Areas

Research question 1:            How do credit events in banks affect LIBOR? There has been a constant spread between the rate at which banks lend each other money and government-backed securities yields in recent months.

Research question 2:            Are there limitations in calculating and estimating LIBOR? What are the effects of governments or central banks directly controlling LIBOR? Recent developments have demonstrated that LIBOR system is arguably corrupt.

Research question 3:            Can LIBOR be improved to serve the market better? How the British Bankers’ Association can recover the trust in LIBOR?

Research question 4:  Is there a better alternative to the LIBOR in developing markets?

These questions are the linchpin of this report and most of the discussions and analyses that follow will revolve around these questions though there will also be an extension discussion on the future shape of LIBOR and the financial markets. This future outlook will put in perspective the requirements of a benchmark in the financial markets of the future years and also entail the expectations of how the financial world will be shaped by LIBOR in the near term.

Literature Review
Background
The report has been prepared while using a number of sources and the author thinks it is important to discuss some of the literature as they were a significant influence on how the opinions of the author formed and how the analyses have been conducted throughout this report. The literature also highlights the various ways of research that were undertaken to complete this research paper.

Literature
Bloomberg,(2009) Interview with Ira Jersey of RBC Capital Markets, Importance and Role of Libor and Libor-OIS spread.

In this interview Ira explains how the Libor has become an important index and what short-comings exist within its formulation and he basically gives an American perspective on the Libor.

Rozens, AlekSandrs, 2008, The trouble with Libor. ‘Does the widely used measure of borrowing costs truly capture rates banks charge each other?

Belton, T. & Roever, A. (2008), A besieged benchmark, CME Group, retrieved from http://www.cmegroup.com/company/history/magazine/Summer2008/guestcolumn.html

The article begins by outlining the significance of LIBOR and the organization responsible for collecting information and calculating it.  According to the authors of this article, some aspects of LIBOR are widely misunderstood and as a result have been illuminated by the intensiveness of the global liquidity crisis.  The article also attempts to provide a better understanding regarding LIBOR and ways of making it better.  The authors lays out potential and most practical proposals for building a better LIBOR, that is more robust and meets the expectations of many banks and investors.  This article contains essential information which will be a major boost for the study.

Christensen, J.H.E. Lopez, J.A and Rudebusch, G.D. (2009), Do Central Bank Liquidity Facilities Affect Interbank Lending Rates?, Federal Reserve Bank of San Francisco working paper series

In response to the global financial crisis that started in August 2007, central banks provided huge amounts of liquidity to the financial system. This paper investigates the effect of central bank liquidity facilities on term interbank lending rate using the six-factor model of U.S. Treasury yields.  (Christensen, et al, 2009).

MacKenzie, D. (2008), What’s in a Number?: The $300 Trillion Question, London Review of Books, vol. 30, issue 18

The article entails issues surrounding LIBOR; entities involved and procedures used in its calculation.  The author also outlines the importance of the information provided by broker in calculating LIBOR and in addition to that the risk of integrity in its calculation as banks in the panel can manipulate the information provided.  The article also contains comprehensive information regarding the importance of LIBOR on inter-bank lending and to the world economy.  Furthermore, the author covers criticisms of LIBOR and its fortifications which will be of much assistance to the study.  As a result of materials contained in this article, it will contribute greatly to the achievement of the research objectives.

Sittampalam, A. (2008), Libor’s future in question, EDHEC-Risk Institute, Investment Management Review

This article outlines that the high level of LIBOR mirrors the fact that the banks are short of capital to lend, particularly for the 3-month period, and LIBOR therefore symbolize a forefront indication of the banks’ capital deficiency. The gap between LIBOR and overnight rates is likely to decline to more normal levels only when the bank’s capital stock is refurbished to sufficient levels. Thus, LIBOR remains a barometer of the financial system’s health.

Shiv Goel, London Interbank Offered rate

Spaulding, W.C. (2008), The London interbank offered rate, retrieved from http://thismatter.com/money/terms/l/libor.htm

This article provides adequate information regarding the definition and significance of LIBOR.  The author also provides a brief overview regarding the history of LIBOR and how it has evolved over years.  Different currencies in which LIBOR is calculated are also outlined clearly in the article as well as the contributor banks for each currency.  Besides the roles played by LIBOR in the financial market, particularly in the lending section, the author also covers factors that affect LIBOR in the market. This article will be major enrichment for the research since it contains crucial information which will used to answer some of the research questions.

Walayat, N. (2009), UK housing market crash and depression forecast 2007 to 2012, The Market Oracle, retrieved from http://www.marketoracle.co.uk/Article8080.html

This article focuses mainly on the UK housing market and its behaviour.  In accordance with a 2007 forecast report, the UK housing market was expected to decline by about 15% in the next two years and by as much as 25% by 2012.  The author also provides reasons which were given to support the rise of the housing market.  Moreover, the article covers in detail the effects of the housing market crash as observed in 2008 and the credit market as measured by LIBOR.  The author of this publication uses graphs adequately to ensure readers get the picture and understand the content clearly.  This article will be useful since it contains materials that support the research.

Crandall, Lou, 2000, Wrightson Associates, FRBNY Economic Policy Review

This article basically is a commentary on how the transition has taken place over the years between important benchmarks.

Methodology, research design and data collection
The research design is such that both secondary and primary sources of data are used to come up the information and some analysis that has been incorporated in this report.

The research will entail collection of secondary data from various sources.  Sampling will be used as the primary data collection method in order to ensure adequate data is availed for the study.  Data sources to be used include journals, magazines, newspaper articles, websites and other sources which will be considered relevant to the research.  Data will be collected mainly from student library, Thomson Reuters, Bloomberg, Nordea Group E-Markets and financial websites since they contain reliable and accurate information.  Following data collection, all data will be assembled and analysed qualitatively and where appropriate tables and charts will be used to provide readers the ease of understanding the research results. The research will also use interviews of banking treasury managers and dealing specialists who were facing the problem of LIBOR inefficiency during the financial crisis.

Real Cases of Libor Inefficiency
When the financial crisis began to unravel in late 2007 few could have predicted the scale of financial devastation that would follow and only a handful might have dared to even speculate the bottom of the major mess that caused failures in the banking industry of unimaginable proportions. In August 2007, one of the first major indicators of the potential devastation that was to entail came in the shape of LIBOR. It is ironic that we begin with a valuable indication from LIBOR a section that talks about the issues with LIBOR. But it is important to note here that most of the issues or problems that are embedded in LIBOR are practical and they have surfaced as a result of a messy financial outbreak. From the theoretical perspective LIBOR continues to be a strong barometer for financial institutions which might be replaced by another benchmark but it will continue to hold a significance place in the financial sector.

LIBOR is an Estimate or an Opinion rather than a Real Measure
A major criticism of the bbalibor is that it is an opinion or an estimate of a banker as to how much would it cost him to borrow unsecured funds though the real life issue here is that inter-bank loans are private arrangements between banks and under no circumstances are these banks obliged by regulation to disclose their reasons behind actual rates and the borrowing or lending rates. What this means is that banks draw us through the LIBOR a picture that they want us to believe in rather than giving us actual rates. Bbalibor claims that it is among the lowest benchmark for borrowing costs; the problem with that claim is that the ultimate cost of borrowing depends on the excess liquidity available with other banks therefore how can we believe a banker to accurately predict the rate that would be offered if he needs short-term unsecured funds.

The problem is further complicated because during the financial crisis it was quite evident that some of the problems that banks faced were caused by Credit Default Swaps (CDS) and off-balance sheet items. Now in such a case imagine how difficult it would have been for bankers and dealers to estimate appropriately the reserve cash position of their peers.

Short-comings of the Data Collection and Calculation Process (LIBOR)
Much of the recent criticism that LIBOR has faced comes from the United States especially with regards to the US dollar Libor; The main critic has been the Wall Street Journal which lately stated that the public eye on rates that banks show as there borrowing cost is a measure to improve transparency but the problem it causes is that banks are afraid to show too high borrowing costs as that would reflect poorly on their credit ratings. Banks want to keep borrowing costs lower or at least show that their borrowing costs are lower because they do not want their customers, creditors and clients to think that they are carrying riskier securities and risky loans on their balance sheets. Worse of all banks also want to avoid credit rating agencies and the potential of facing a downgrade in their ratings.

This again shows that banks that are part of the panel of BBA have every reason to down play their borrowing costs. It is important however to note that BBA’s counter argument is that they use a trimmed arithmetic mean which doesn’t include the outlier values which are under rated though what the BBA is not recognizing here is the fact that since banks do not know what each of them is quoting, BBA might end up calculating underestimated LIBOR because the rates that BBA considered were understated more than those rates which were eliminated for being outliers.

Another technical and real life problem with US-3 month LIBOR rates, which are the main benchmark for the swap market, is that they are set at around 11.30 am London time whereas during that hour in the US treasury workers and dealers are only making their way to the offices henceforth they have little or no clue as to how to respond to the initial trading rounds.

The US analysts also complain about the fact that there are not too many recognizable American banks in the panel that BBA maintains. This lack of representation means that only a handful of American banks represent the world’s largest economy and one of the largest financial markets; this eventually means that the US Libor can not be considered a fair benchmark for US dollar denominated loans and arrangements.

In early 2008 it was discovered that borrowing costs, futures currency market were higher than the level they are supposed to maintain. To explain the problem imagine a bank goes to the central bank of England, which is Bank of England, and asks for a loan for 3-months; this loan is taken with a promise or commitment that this borrowed sum can be taken to the futures market and this bank can borrow for the same period US dollars. Now this second exchange takes place within the forward currency market and it gives investors and banks an idea about the implied costs of loans and borrowing; in early 2008 this implied borrowing cost was higher than the 3-month US Libor which means that at that time certain banks were hiding their true borrowing costs to ensure that their credit worthiness is not questioned by institutions and creditors. (Rozens, 2008)

From an overall perspective the calculation process used by BBA has certain limitations and later we will look at ways in which these problems can be resolved or overcome; some of the problems are inherit and cannot be resolved because of how the system works. For example the time difference between New York and London cannot be removed and to ensure that markets work properly in the near future US might have to develop its own index as do other regions.

One other factor that must be highlighted here is the way the ultimate rates are calculated; but trimming the arithmetic mean BBA is acting like a regulatory authority which ensures that rates that reach the public and the institutions for financial products packaging and selling are limited and tampered with; a better solution would be to avoid the use of arithmetic mean that has been trimmed rather the median value should be used. Firstly it takes into consideration all the values; secondly to ensure transparency BBA should introduce newer regulations or investigation policies rather than not including rates that are provided by banks.

These measures will not only strengthen LIBOR but also give the accurate opinion and direction of all major banks; if a particular bank is really trying to change the direction of the LIBOR rate by providing too low or too high rates than one of the two things would be true; firstly either its manipulative behavior whereby the bank is trying to hide its creditworthiness or the bank has done something right which other banks need to follow in a crisis such as the one we recently witnessed. In this way we will have all possible options and investigations in front of us and rather than having a preventive and cautious approach the BBA must have an aggressive and pro-active approach toward keeping the calculations of LIBOR as free of any changes and trimming as possible.

Weighing Disadvantages/Cost versus Advantages/Benefit of Libor
In the previous discussion we looked at some of the real world practical issues that have been caused by Libor and some of the pro-Libor arguments from BBA though in this section we would like to weigh up all major disadvantages of Libor against the potential advantages of this benchmark. First we will discuss some of the disadvantages that exist within the Libor yields.

The idea of having just three American banks in the panel of contributor banks is not a good one; this factor has drawn considerable attention and criticism from the American media and economic/financial analysts who believe that going forward America should have its own Libor-like benchmark. The idea of having a number of banks from various regions and countries is a good one but it must be understood here that the American banking industry is a major player in the world financial system and therefore it should be given greater representation. One of the suggestions that will be explained in detail later is that BBA should go ahead and open up offices in New York and look to develop a sister index of Libor that it issues from New York. A more detailed analysis is discussed in the later chapters.

We also like to discuss another disadvantage that we feel has reduced the credibility and integrity of Libor as a benchmark. By quoting and giving out daily rates on 10 different currencies BBA has Libor an ever changing benchmark; a much better approach would be to come up with weekly or fortnightly rates because banks and financial institutions need and require stability. This move will also allow BBA to focus on long-term factors that impact the banking sector and the financial markets.

We also believe that BBA should look at the question that it asks the panel banks every morning when it asks banks to submit them their borrowing costs on unsecured loans. In our opinion leaving the market size open to the banks discretion gives them unnecessary freedom to factor in all sorts of things into the cost of borrowing. The point here is that the definition of bbalibor should be definitive and concrete rather than open to interpretation; only BBA should have the right to provide banks with interpretations and the best case scenario would be when there is only one interpretation and all the revolving factors are fixed or known quantities to the banks. Although this new measure will again be an estimate or an opinion but it will have proper and quantitative backing that could be used effectively for investigations into mal-practice by panel banks and also as a barometer for financial institutions. The advantage of such a system would be that financial institutions would be in a position to stimulate and come up with a number of simulations and forecasting and predicting future trends would become much easier. This new yield table would also allow users to factor in information in the case if it is found that for a particular period the rate is higher or lower by the bbalibor. The difference could be explained mathematically.

It seems that BBA has lacked the necessary skill of combining expertise with associations and agencies of other regions and economies; this is obvious because it has failed to come up with working offices in Far East markets and North America where a large amount of Libor related trade takes place. This lack of acceptance of the global challenge has caused the world financial markets considerable discomfort as far as our analysis is concerned. If for instance BBA had established its footings in New York than the necessary covering steps would have been taken for this present looming European banking crisis.

All in all we have highlighted some of the major weaknesses that we believe exist in the Libor system of rates and yields calculation. By looking into some of these points major changes could be achieved and problem areas could be resolved. We will now look at some of the major areas of advantage and benefit that BBA has been able to bring to the table through Libor.

For all of its issues and problems Libor has a number of strengths and advantages that have benefited the world financial system and institutions. First of all we need to understand that Libor has been a single most powerful measure of bank’s borrowing costs for over two decades now and it has been used in all the derivate and swap markets that have recently developed and come into existents. So firstly we need to understand that Libor is a crucial benchmark for so many of the modern forwards market that on its own it has been the basis for pricing of these instruments.

Secondly we also need to understand that the Libor is a benchmark of the global economy rather than the benchmark of only one region or country therefore it has greater depth and stability. Libor is in some ways biased toward the European markets and financial institutions in London but than London is in effect one of the few major financial markets of the world. Therefore we believe that in actual there is no harm in having different measures and world views about similar markets or different markets such as US treasury fund rates and Libor.

There are many advantages of Libor, for one it is a benchmark that is used to understand the financial health of the Euro zone more specifically the health of the financial system within Europe. This is extremely important for investors who consider Europe as a major market for portfolio investments and institutional investments. It must be understood here that this singular benchmark provides all the necessary information in nutshell to so many users which include global banks, institutions, governments and other financial institutions.

Libor also provides considerable amount of transparency by allowing leading banks of the world to set their benchmark lending and borrowing rate. This was such a crucial move in the mid and late 80s that Libor came to replace the Treasury yields and became the world’s leading benchmark. We must understand that because of its dynamic factors and robustness Libor became a leading measure during the 90s and early to mid part of the 2000s. In many ways so many of the products that we see today in the financial world were a result of the labor rates because it provided that singular and all powerful ability to borrowers and lenders the right to create new and various kinds of products based on a viable pricing system.

In recent times, ever since the global financial crisis, we have seen Libor taking on a new role of acting as an indicator of potential future financial distress. The rate has been able to tell markets and leading experts like Alan Greenspan when and how markets will react in the near term. Interestingly Libor has been able to tell us a lot about the liquidity of the market and many experts consider the benchmark as a potent liquidity indicator and Libor also shows that whether banks have confidence to lend money to their peers for the short-term. This is an extremely important indicator because the short-term liquidity in the market determines the long-run direction of the monetary policy at least in part this is because banks are such an important part of all economies that without their proper functioning we can not expect other industries to really outshine.

We also need to realize that Libor is kind of a central bank interest rate type indicator so when interest rates increase in an economy Libor is also supposed to rise therefore this index provides European economies a way of controlling money supply and demand in their respective economies to control inflation and spur growth. Again Libor plays a critical role because unless you have a credible and singular index it is extremely difficult to bring in stability and control in the economy.

It is also a legitimate and workable way for banks to show their credit worthiness and their ability to do good things for the economy. The real goal is to rule through people and in this case BBA until recently successfully ensured that banks were providing credible estimates of their borrowing costs for the world and general public to see and use. Many people in the US might say that Libor has failed the ultimate acid test but lets be fair to banks and the BBA, Libor has lived up to everybody’s expectation but it did signal the need to address the woes of some of the banks when the gap between US treasury fund rates and Libor started to increase in early August, 2007.

The both sides of the story that is the advantages and disadvantages of Libor have allowed us to look at the overall picture and evaluate the bbalibor in its truest sense. We must conclude here that Libor is here to stay but with certain necessary changes otherwise a more potent yardstick or measure will surely take over Libor. Secondly these changes are a result of the reset that has taken place in the financial markets therefore in light of the new regulations and changes in financial systems Libor will have to set itself up to meet the new challenges.

The idea here is to provide you with adequate information about how Libor has the capability of overcoming its problems though it must be done as soon as possible because patience in the US might be running out. The critical steps that would be necessary to match the Libor to newer expectations would be discussed and elaborated upon in much detail later but what is absolutely necessary to highlight here is that BBA must expand its horizons and move into newer directions and come up with regional indexes as well to support the all important singular Libor.

Data Analysis and Evaluation of LIBOR as an Indicator
The diagram below has been sourced from a working paper that was prepared for Federal Reserve Bank of San Francisco. The diagram below explains the difference between LIBOR and US treasury rates which are considered credit risk free in the US.

  source: Do Central Bank Liquidity Facilities Affect Interbank Lending Rates?, Christensen, Lopez and Rudebusch,2009

The diagram above explains that after the announcement of major central banks of the world economies the gap or the spread between LIBOR and US Treasury rates fell drastically; these announcements were related to the bail out packages and the intervention by central banks of major economies such as the US to provide emergency liquidity to banks which were choked and as a result were holding their respective economies hostage to a dangerous credit crunch scenario.

The counterfactual curve shows that the LIBOR and Treasury spread would have continued if the central banks had not interfered. This also shows that rising spreads between LIBOR and Treasury rates are an indication of credit crunch and a looming financial crisis. It is also important to note here that if BBA can ensure through stringent investigative regulations a close to accurate LIBOR than in future financial crises could be predicted based on the LIBOR movements as against the Treasury fund rates.

An important consideration here is that after mid-December 2007 the spread between  bank debt and LIBOR yields remained extremely large and we would like to explain this large spread by shedding light on the varying concerns that exist among lending classes; The market that is catered by LIBOR rates is the short-term funding market that mainly consists of banks that lend and borrow to and from each other for short periods of time whereas the bank bond market consists of customers who own debt obligations in banks but they belong mostly from nonbanking institutions. Although both of these set of lenders would give equal importance to credit default risks but when it comes to liquidity they have different views and we see that the interbank market was eased of the crunch stresses more than that of the bond market lenders who were more worried about the long-term sustainability of banks and the bad debts on their balance sheets that might ultimately erode most of their values. (Christensen, Lopez and Rudebusch, 2009)

Role of LIBOR in Major Credit Events of a Financial Institution
As we have already discussed that Libor is a major indicator and plays a critical role in determining the price of swap deals, syndicated loans, and other forward and futures market contracts therefore when two banks come together to form a contract or borrow to or lend from one another than LIBOR plays the critical role of acting as the base rate for these institutions. A rising gap between the Libor and OIS (Overnight Interest Swaps) indicate that banks have a lack confidence amongst each other and they are reluctant to lend to each other because they are afraid with regards to the hidden problems in each others balance sheets. Ultimately what this tells us is that banks show their measure of confidence in other banks through the LIBOR.

The interference by the central banks to ease out the liquidity position of the markets also showed that LIBOR is in a way a public-private partnership through which financial markets are regulated. The decline in the spread between Treasury funds rate and LIBOR rates was a result of the intervention by central banks and in a sense it was the governments of these respective countries playing as the lender of the last resort.

A crucial point that we need to look at is that LIBOR is set by large banks themselves, at least in part, therefore it is up to them to decide their own creditworthiness and position in the market; the power of LIBOR is acceptable in this sense that it did show a rising trend and the spreads widened between LIBOR and Treasury Yields.

Controlling the LIBOR rates is probably as important as the central bank’s benchmark interest rate. It is necessary to understand that increases in LIBOR rates tell us one of two things firstly either the general level of interest rates are rising in the various economies of the world or the banks that are supposed to lend money to other banks are too afraid to lend their funds because of the increased risk of default let alone the paying back of the loan.

So what this explains us is that economists and policy makers around the globe want to see LIBOR dropping because that is an indication of rising confidence and trust among banks to lend each other for their short-term needs secondly the general interest levels are falling and that also is a good indicator for businesses and the economy as more funds are available for businesses to grow and new opportunities to be exploited.

Explanation of LIBOR-OIS Spread by Industry Experts and Analysis by the Author
According to Ira Jersey of RBC Capital Markets LIBOR-OIS is an important liquidity indicator; in this interview that he delivered in May 2009 he explained that Libor-OIS spread shows and determines the willingness of banks to lend to each other especially for the 3-month US dollar loans; he continued to explain that the levels of Libor and the treasury fund rates show that banks have a lot of funds to lend out due to government and central bank programs but they are reluctant to loan out just yet because they feel the counterparty risk is high and even though central banks have injected funds a crucial factor remains the survivability of banks and other financial institutions. (Bloomberg, 2009)

This discussion above again highlights the importance of Libor as we must understand that it indicates borrowing costs for unsecured loans therefore Libor rates are one of a kind and they are an important indicator of the inter-bank market of the world. Alan Greenspan also considered Libor-OIS spread as an important liquidity indicator; we see here again that because Libor is used to formulate and price important and large amounts of swaps, loans, and other forward contracts therefore financial institutions look at it as a source rate or base rate. This is only because it is considered more efficient than central bank rates or treasury yield rates.

Analyzing the Impact of the Current European Debt Crisis on Libor
The current crisis that has plagued the world markets again after a weak recovery in the initial months of the year we see that European countries that had bailed out their respective banks have gotten into the strangle hold of a debt crisis whereby the governments of countries like Portugal, Greece, Iceland, Ireland and Spain are finding it difficult to control their public debts and fulfill their debt servicing costs. What this means is that Libor which had come down to a reasonable level had started to rise again because banks all over the world are fearing about the credit risk of major European banks. The repercussions that this rise in Libor will have eventually could be devastating for Europe in the sense that the region needs new businesses and the economies in Europe need money and funding to come to the growth path; if their governments have to cut their expenditure to meet budgetary requirements than that should not mean lack or expensive funds for the private sector.

The bottom line is that Libor is a reliable measure and indicator for assessing the future trend of the financial markets and borrowing costs trends. Therefore it should be the top priority of European governments to look at their balance sheets carefully and than ensure that Libor is brought back to sustainable levels so that economic growth does not suffer otherwise we may see a double dip that will cause further economic strains to the world economy.

Discussions, Findings and Forecasts
Deliberation and Discussion on Data Gathered
We have explained and described a number of scenarios, facts, circumstances and events that have shaped the recent past. The financial crisis which was triggered by the subprime mortgage crisis and later aggravated by CDS issues and liquidity crunch brought almost all aspects of the financial system under scrutiny. Analysts and economist all around the world said that the world would never be the same before as new regulations and sets of principles would be introduced in the financial systems. Banks came under serious hammering and many major banks like Citigroup were asked tough questions about their actions that many believed led to the financial crisis.

When we even try to put all of these events and landmark happenings we forget a major factor that created a two fold impact of the grave financial crisis. That factor is the declining health of the manufacturing sector of the US. Before the looming financial crisis US had witnessed a steady decline in the prices of home values as a result of the end of the debt bubble coupled with that manufacturing in the US was steadily losing its competitiveness to Japanese and the Chinese in particular. It should be understood here that the financial sector is in a lot of ways dependent and based on the performance of the secondary sector of any economy. The underlying assets in many of the financial products are either home mortgages or equities. So we must understand that the mess we are in today was created over a long period of time. Just like the American car manufacturers steadily lost their competitiveness to Japanese carmakers.

Now we are at a stage where we see that Asian and other developing countries that are growing rapidly are the producers of most goods and services and the western more developed economies are borrowing and buying these goods and services. The end result is a looming debt crisis that has held many European economies hostage.

In the backdrop of all this analysis we must look at the gaps in the financial sector specifically from the perspective of the bbalibor. How do these factors impact the Libor that has for over two decades serviced the world financial markets?  Well, for starters we have some credible information that has been discussed previously that explains that Libor did fail to provide an absolutely accurate measure of the borrowing costs at the height of the financial crisis. That brings us to the point that whether banks that form the panel of the bbalibor data collection manipulated their data to show an improved version of their credit worthiness which in fact did not exist or there were errors in data gathering and data collection. Research shows that the former is true and the latter is not.

Once we are assured that banks in the bbalibor did try to manipulate their borrowing costs we come to the question that whether we should scrap this measure (Libor) and come up with some new measure or look at its weaknesses and correct them. Well in our opinion it is quite evident that Libor has a long way to go before any new measure to replace it. We believe that certain changes are surely in order and careful deliberation should lead to changes that are acceptable to the American experts and financial top dogs.

We have already in depth explained and analyzed the advantages that Libor has over many other indexes and to the economies and its various stakeholders. Most notably the critical point is that Libor has come out as an indicator of financial health of markets. Libor has the potential to explain some of the problems that are being faced by the financial markets in a particular region. Its ability to act as a barometer makes it an exceptionally important measure since it can help governments and central banks avoid future financial meltdowns and crises.

The second important point is that we must accept that bankers made mistakes when they went into unchartered territory of CDOs, CDS, and other collateralized obligations, and their punishment should not be misplaced on a measure that was the first to point out and give us the alarm. Here, we need to realize that now we understand the loopholes in our financial systems much better and it is time to capitalize on this opportunity and plug those gaps rather than go on another rampage and change our barometers and bring in new indexes that have their own unknown limitations. In our opinion this is the ideal time to give the right direction to Libor by making certain needed changes and move ahead to making important and needed regulations that can control investment motivation and mentality rather than the profitability of banks.

Moreover we would like to comment here that rating agencies have played a devastating role in destroying many financial institutions because we must understand that it’s all about confidence and reputation and when all of us were standing on thin ice than there was no point in putting the blame on one single bank or institution. The ratings agencies should have taken a step back and assessed the situation and indulged in back door negotiations with the governments and regulators to overcome this financial mess.

We would go as far as saying that it should be measures such as the Libor and US treasury yields that indicate financial crises or issues rather than credit rating agencies stepping up and putting a bad name to a bank or financial institution. Look the idea here is not to give banks license to kill but because banks are so intertwined and linked to each other that before any such call is made we believe that the regulator is taken into confidence so that every effort is made to secure lost dollars or funds.

Major Findings from the Research Effort and Analysis
There are a number of factors and evidence that have been considered and used to reach many conclusions. These conclusions are substantiated by data that was gathered through primary and secondary research. It is worth noting here that on this topic there is not a lot of online reports and data available but the author has used information from various sources to come to these conclusions and findings.

Firstly, backed by research, we recommend that BBA should come up with a similar index specifically for the US market and start its own operations from New York this will increase the work load for BBA but it will provide valuable data and information. A similar index in the US will allow BBA to compare Libor and the US index and look at the anomalies if they come into play eventually. The other advantage would be that banks in the US that have extensive operations in the world’s largest economy would be in a position to contribute to the average borrowing fund costs. This step would single headedly solve half of the complaints and criticism from US quarters that BBA has faced. This step should be looked in to objectively because BBA has the expertise all it needs is investment and human expertise in New York.

On the surface it will solve two problems firstly the issue of minimum US banks representation on a major world index secondly the time issue of Libor which is issued at 11.30 am London time. However we believe that the step would have multiple benefits; significantly it would reduce the mathematical errors and allow BBA to independently reconcile its Libor rates with the new proposed US index.

The other important findings that we have concluded to is that BBA should not ask the banks to provide yield rates in all 10 currencies because it is a useless practice; banks should only report those currencies that they trade in and have active stakes. This is substantiated with the analysis that Libor rates are an estimate therefore they should only exist for those rates that actually exist and are traded on the market.

Another important finding during the research process was that in our opinion the calculation method is a bit flawed because it goes against its principle of transparent flow of information. From the perspective of a user of Libor data think of it as a manipulation because the user will look at the average cost of borrowing for all banks at the lowest possible level with the trimming of upper and lower quartiles. In our opinion this data is flawed and it does not truly reflect the estimates of the borrowing costs that banks think they might have to pay for short-term unsecured loans.

A significant finding was that Libor and Treasury Yield spreads rose significantly when more and more news of failing banks and deepening financial crisis was unraveled this again explains that Libor is a liquidity indicator that explains two important risk factors. Firstly, how banks consider the liquidity position of their peer banks and secondly the consideration that banks give to credit risks of each other. This is essentially is the risk of the banks being vulnerable to default.

There was discussion on how the bbalibor overtook the treasury yield rates during the early 1980s. We believe that a similar event can occur again as we move towards more uncertain times given the deepening Euro debt crisis. This obviously does not mean that Libor will be abolished; we think just like the treasury yields continued to offer their qualities to investors Libor will also continue to do so but eventually in the long run fail to come up to the needs of the financial markets.

The deliberations that were undertaken in prior sections also provided us with the understanding of the question that BBA asks every bank in the panel at the beginning of its data collection everyday. We think that the question is to open ended at it allows banks to factor in all kinds of data regarding financial markets, money movements and so on. Our findings suggest that BBA should look to provide closed ended data and quantitatively collect data from these banks so that the estimates are much closer to actual data.

What we are saying here is that BBA should let the banks decide what they want to keep as their borrowing costs but BBA should fix the market size, borrowing amounts and lengths. This will help BBA to set in stronger regulations and put BBA in a position to enforce these regulations in a more stringent and accurate ways.

A final finding was related to the fact that BBA does not collect any reliable data from banks that provide outlier data. We think that BBA should ask these banks with adequate explanation there and then about the significant difference. This will again help to reduce manipulative behavior and increase the chances of a more accurate Libor rates.

Ultimately we must understand that these findings are from the perspective of how financial markets could benefit from the changes in Libor; secondly we believe that Libor has the potential to fulfill the current needs of the financial markets. The benchmark can be used to fulfill the needs of all kinds of users such as regulators, economists, fund managers, bankers and investors. This is because its ability and capability to change to the requirements of the reset financial environment.

Suggestions and Recommendations
One of the major changes that we propose to the BBA for its Libor measure is to change its trimmed arithmetic mean and use the median. We think that the median is a better measure because it takes into account all values of the data collection process and it also provides a more accurate measure of the rate that should be charged as a borrowing cost. The median is considered a more representative measure compared to the arithmetic mean. This is important also because firstly the difference between the median and mean would be minimal during stable times but there will be changes during uncertain times and that is exactly what we need to find when such times impact financial markets in the future.

Another critical suggestion is that the number of banks that are within the panel right now should be increased regardless of the fact whether BBA decides to go to New York or not but it should increase the number of US banks in the panel and look at various banks carefully because certain banks like Well Fargo are huge but they have a large retail base as against interbank operations. This will also be an important change because it creates a more balanced portfolio of banks that have adequate representation from two major markets i.e. Euro Zone and North America.

The third suggestion is about the time zone that is being currently used by bbalibor. We suggest that to overcome some of the troubles BBA should come out with the Libor rates at around 10.a.m New York time. This will allow the all important economic data to be factored into the Euro-dollar market in London. On the contrary changing the time horizon will cause a lot of banks in the smaller European countries to be left unfunded that heavily depend on US funds because of delays in the Euro Zone announcements. Secondly other panel banks from the UK which forms the majority of the panel, 13 out of 16 will have to change their timings and leave employees later by up to 5 hours.

Another important suggestion is related to the definition that is being currently used along with the question that is asked. Apart from the changes that are suggested above which are a result of analysis and deliberation; these changes that we propose are suggestions and we believe that they can help solve some of the issues. Firstly the borrowing costs should be for a top rated bank in the particular currency loan this is because we believe that by keeping high credit standards BBA would be able to maintain a stable Libor. Secondly the definition should give a lot of consideration to the market size because Libor is a classic indicator of the unsecured market therefore that is an important component of the whole definition.

The bbalibor benchmark is an all important index that plays a vital role not only in the European markets but also in the global markets therefore it might be in order to bring in certain slight changes that have been proposed above. It should be brought to light here that the limitations of Libor are a result of a financial catastrophe of unprecedented scale therefore it would be unfair to bring fatal changes to the index. Financial regulators and governments would be better off if they can ensure that Libor can continue on its path with certain suggested changes. The ultimate and final changes could only be brought to floor and discussion once new regulations on banking and other financial products have panned out and we know what is the legal position of so many of the derivatives and forward rates.

Conclusion
We began our discussion with a concrete and factual discussion on how the Libor came into existence and what are the basics behind this indicator. We discussed the definition, data collection process, and the calculation process. We deducted that BBA takes a serious and extensive approach toward calculating Libor and at the same time it also disseminates all of the information to a worldwide audience. It is extremely important to understand that Libor’s calculation process and every other detailed steps has a particular reason that is explained by BBA though we believe that some of the assumptions are obsolete and they should be changed or improved upon.

The gist behind this research paper is to find credible justification behind any potential change that is absolutely necessary to make Libor more efficient and robust. This is important because the financial scenario that we face today is extremely rare and the chances of such a crisis happening are minimal therefore we should not change things for the sake of it. Secondly BBA has done a lot of things right with Libor therefore we do not consider it as a necessity to bring in changes without solid facts and purpose.

However there are certain changes that are in order; for example BBA must take some steps to enhance and better balance the panel of banks from which it collects information and data on borrowing costs. Secondly there is enough evidence to suggest that tougher regulation is required to ensure that banks do not manipulate their borrowing costs therefore the definition should be quantified so should the question that is asked by BBA from banks. This step will allow BBA to take tougher regulation stance against banks if they step outside of the line and it will also give BBA more investigative power since we believe that quantitative data would provide BBA with hard evidence.

Libor has all the ingredients that are necessary to provide banks with a free-market measure to control their own cost structure but to ensure no foul play takes place a strong and focused regulator can help improve the financial systems of the world.

Further Research on the Work
We think that there a few areas that could be singled out for further research work. Firstly there is a strong case to research the impact of opening a new operation at New York by BBA to calculate an index rate for primarily the US market. The second research should be done as a sampling effort or simulation of how would Libor change and vary if more banks from the US were included into the panel.

A particular area that we think that should really be explored and researched into is the potential of developing Libor like rates for all major markets of the world. This effort could be undertaken into three stages whereby Asian emerging countries should be covered in the first stage followed by the Euro Zone and than the North American economies. The yields for each of these regions would give extreme accuracy to pricing formulas of various financial products. In our opinion another potential replacement for Libor could be a Swap rate yield. This index could be typically used to value and price swap deals among various institutions.

Looking forward there are numerous steps that could be taken by banks and other financial institutions to give credibility to an index such as Libor. It is important to understand though that the basis of any such index should be firmly placed on market fundamentals and the kind of economy it wants to work within. By that what we mean is that if the Euro Zone plans to practice near free-market economics in the near to medium term than it should look to develop Libor in such a way that it strengthens free-market principles that govern financial markets i.e. money markets should be allowed to determine the cost of funds in the open market with strict implementation of law only from the state or central bank.

Appendix 1
Questionnaire for Primary Interview

1.      Explain the importance of Libor to your treasury operations.

2.      How relevant and accurate is the data given by panel banks to BBA for Libor calculation in your opinion?

3.      Please explain the process of pricing of one of the products in your bank or industry that uses Libor as a basis.

4.      Do you think Libor is a viable barometer for global markets to assess financial markets health?

5.      Is Libor an efficient or robust index for estimating borrowing costs in the interbank market?

6.      How has the financial crisis impacted your operations and bank?

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