Can LIBOR regain credibility?

The very existence of the London Interbank Offered Rate (Libor) has been threatened by the escalating scandal involving banks allegedly manipulating the rate during the credit crisis.

 

The credibility of the benchmark, which has been in place for nearly three decades, and affects everything from the survival of the world’s biggest banks to interest rates for ordinary savers, has been dented. Ben Bernanke, US Federal Reserve chairman, told Congress Tuesday that it is “structurally flawed.” International efforts to reform the benchmark rate are underway.
The revelations about artificial lowering of the rate, which helped mislead markets about banks’ willingness to lend to each other, have already claimed the job of ex-Barclays Chief Executive Bob Diamond. More scalps are likely to follow as the investigation continues.
So, will Libor itself be killed off? Or can it survive in a different form

Totally eliminating the rate, which is used to set rates for an estimated $800 trillion of derivatives and debt, sends shivers down spines in London and Wall Street.
“The size of the markets which reference Libor is so large that to abandon or radically alter it would cause unpredictable consequences,” Laurence Mutkin, European interest rate strategist at Morgan Stanley, pointed out.

A new futures contract known as the GCF (“General Collateral Financing) Repo Index Futures, launched on Monday and traded on NYSE Euronext, has been touted as a possible alternative, but pessimists believe that it is too short-term to reflect the overall tone of the market.
The British Bankers’ Association was already considering changing the way Libor was set before the scandal erupted – and this consultation has been made more urgent by recent events.

How to Fix Libor

What exactly can be done to fix the Libor system or is it worth fixing at all? Catherine Boyle has more.

 

At the moment, Libor is set at around 11am London time, when the banks involved in the panel which set it send the rate at which they are lending money to other banks to Thomson Reuters, via a secure network. The highest and lowest quartile rates are removed and the average of the remaining rates becomes Libor.

This basic model is followed by other inter-bank lending rate-setting panels around the world, who will doubtless be watching London closely. Several banks have quit these panels in recent days as the Libor fallout grew. Royal Bank of Scotland , for example, has left the panel which sets the Libor equivalent in Tokyo, Hong Kong and Singapore. If banks continue to drop out of setting the rate, this could itself cause its demise.

One point in Libor’s favor is that it does, with notable exceptions such as during the US sub-prime crisis, generally reflects what is in the market, as Mutkin points out. Another is that it is useful for market stability to have a benchmark rate based on three-month rather than less stable day-to-day lending.

Mutkin believes that part of the problem is that the Libor panel is just not asked the right question to reflect market realities.

“The Libor panel question as it now stands could well be re-phrased as: ‘At what rate would you do a transaction which you haven’t used much for funding during the past 20 years, and which Basel regulations discourage you from doing?’” he wrote.

The key message from London sources is that for Libor to regain credibility, it will have to become the basis for real transactions. Roughly speaking, it has to be real rather than conceptual.

One suggestion is the bank which submits the lowest rate to the panel should then be obliged to lend a set amount of money at that rate to other banks. The amount should be substantial but not enough to materially affect the bank.

The BBA could also use more up-to-date technology than the current secure network to take the Libor sample. If all Libor transactions were monitored by a single mechanism which then took an average, this argument goes, banks wouldn’t be able to fix the rates at an artificially low or high rate.
Broadening the sample beyond the 15 banks currently used to set the euro rate (the sterling panel has 16 banks and the dollar 18) is another option. Or the rate could be set by a new body rather than the BBA.

Whatever the eventual solution, the message coming from trading desks around the financial sector is that change is inevitable

Internal Polical Risk

Banks regularly take active measures to manage and minimize risks that are inherent in our industry. These include credit risks, interest rate risks, operational risks, compliance risks, legal risks and even reputational risks. 

However, I believe there is one key risk that is the most neglected risk of all from a performance management standpoint: internal political risk.

What is internal political risk? It's a very weak operating culture, and it results from ongoing and unsettled disputes among different departments and individuals within the bank. Poor communication and weak leadership are to blame, as it nurtures the constant quarreling, disgruntled relationships and failure to fulfill organizational goals.

I have noted in my years of experience that few banks have a truly effective culture, while the rest are inhibited by selfish attitudes and organizational ineffectiveness. Banks must take a stand against this shattered culture syndrome or suffer the repercussions of a fractured chain of command, low employee morale, reduced productivity, high employee turnover, weak customer service and poor work quality.

Establishing a solid operating culture starts at the very top of the organization. The board of directors and senior management must come together to define the values and characteristics the bank intends to operate under and grow with long term. More specifically, values need to be integrated with shared beliefs and a powerful business mission into an energizing narrative that uniquely positions the bank for growth and profitability. Without this integration, real change is unlikely to occur, leaving the bank to continue floundering in a toxic culture that will undoubtedly preclude it from reaching its full potential.

Once a cultural framework is established and corporate values are identified, a detailed plan can be constructed to fully immerse all relevant parties in the new culture.  Coordinated, purposeful and comprehensive internal communication must be established to signal to the staff that a meaningful cultural change is underway.  A key element of this plan may be a companywide employee engagement event focused on getting staff to also serve as brand advocates. This will instill a strong sense of employee pride in the organization and build a deeper emotional connection between the employee and the bank.

Additionally, efforts to reward sound values and behaviors, in the form of an established employee recognition program, can contribute to strengthening your culture. In my opinion, these steps counteract the most widespread banking industry weakness:  a lack of accountability for results
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I urge you to actively and thoughtfully design the culture you want, one that promotes your values, teamwork, customer satisfaction, innovation, change, accountability, employee achievement and effective communication. Build it into your branding and marketing efforts. Feel and see the difference. Make the message of your strong culture resonate profoundly with your customers.  Keep it vibrant, trendy, topical and fresh.  Make it fun.  Renovating your bank's culture will elevate your bank's performance.  And in the process, you will have one less risk to worry about.