In a move intended to ease the uncertainty surrounding the future role of LIBOR (the London Interbank Offered Rate), on September 28, 2012, Martin Wheatley of the United Kingdom’s Financial Services Authority (the FSA) offered a path to overhauling the benchmark interest rate. The integrity of LIBOR, which is tied to more than $300 trillion in financial contracts globally, has been in question since 2008, when the first accusations of manipulation arose. The LIBOR scandal reached new heights in June of this year when Barclays Bank PLC settled charges that its traders had manipulated LIBOR for financial gain and the bank agreed to pay more than $450 million in penalties. At least 16 other financial institutions have been accused by regulators and/or private investors of manipulating or colluding to manipulate LIBOR.
Since its inception in 1986, LIBOR has been overseen by the British Banking Association (the BBA), a private trade association, and has been set on a daily basis using a composite of rates submitted by major banks, the so-called “panel banks.” The panel banks’ rate submissions are supposed to be representative of the rates at which they could borrow funds. However, the correlation of these submissions to rates at which the panel banks might actually borrow, given their financial health and other predictive metrics, has come to be viewed with increasing skepticism – particularly in view of the admissions by Barclays. Indeed, U.S. Treasury Secretary Timothy Geithner, speaking to the U.S. House Financial Services Committee in late July, noted his belief that LIBOR was quite vulnerable to misreporting. Gary Gensler, Chairman of the Commodity Futures Trading Commission, echoed Secretary Geithner’s concerns in a speech to the European Parliament in late September. “It is time,” Gensler urged European Union lawmakers, for “a healthy benchmark anchored in actual, observable market transactions . . . to restore the confidence of people around the globe.”
In the wake of the Barclays settlement, in early June the FSA commissioned Martin Wheatley to review the current state of LIBOR and propose ways to reform it. Wheatley, who currently serves as the Managing Director of the FSA, is scheduled to become Chief Executive Officer of the U.K.’s Financial Conduct Authority (the FCA) when it splits from the FSA in 2013. The FCA will operate as part of the Bank of England, which will be responsible for regulating the U.K. financial sector.
Wheatley’s proposed reform of LIBOR, which he announced in a speech in London accompanied by a lengthy written report, is intended to raise public confidence in the beleaguered benchmark by, generally, ensuring that data used in its daily construction is based on actual market transactions to the greatest extent possible. Wheatley’s recommendations include the following:
Oversight of LIBOR should be taken from the BBA and transitioned to another private organization, ideally within the next six months but in any event within the next year. Wheatley extended an invitation to parties willing to assume the responsibility; Bloomberg LP, NYSE Euronext and Thomson Reuters Corp., which currently performs daily LIBOR calculations on behalf of the BBA, have reportedly expressed interest in taking on the job.
Regulators should develop an overarching policy approach to the composition of LIBOR and the inputs that go into that calculation and should impose a new daily auditing system to ensure that submitting banks cannot understate rates to improve the appearance of their financial condition.
The FSA and/or the FCA should have increased authority to regulate the submitting panel banks and to approve the individual bank officials responsible for submitting rates to LIBOR.
A code of conduct for submitting panel banks and other participants should be established, and civil and/or criminal penalties should be imposed for fraudulent data submissions or other manipulation of LIBOR.
Currencies and maturities where little or no actual market data is available should be removed from the LIBOR equation. LIBOR is currently offered in 10 different currencies. Wheatley proposes paring this down to five by discarding the Australian, Canadian and New Zealand dollar rates as well as the Danish krone and Swedish krona rates because the composite rate for these currencies is unreliable due to the relatively small number of banks available to submit rates. Similarly, Wheatley suggests that rates with maturities of less than seven months, which are generally less liquid than rates with longer maturities, should not be included in LIBOR calculations and he proposes to reduce the number of LIBOR reference rates from 150 to 20.
The number of banks on the LIBOR submission panel should be expanded, possibly through regulatory requirements. Currently, 18 banks submit data for the primary LIBOR rate, which is measured in U.S. dollars. Wheatley believes that increasing the number of submitting banks would decrease the opportunity for rate manipulation. Some industry participants have pointed out that including additional banks would mean including smaller banks and would likely result in a lessening of the average credit quality of the panel and therefore an increase in average LIBOR rates.
Panel banks’ submissions should be kept confidential for a period of at least three months to reduce the incentive for banks to artificially lower their stated borrowing costs with the intention of implying a misleadingly positive financial condition to the markets.
An international oversight body, such as the Financial Stability Board (the FSB), should embark on an effort to weed out rate-rigging or other manipulation of the interest rates underlying global financial contracts. The FSB is a regulatory task force of developed and emerging market countries around the world and has engaged in a review of LIBOR.
Following the reasoning posed by the Investment Company Institute and others, Wheatley expressed his belief that LIBOR should not be replaced by another interest rate benchmark because no superior alternatives were clearly available and such a move would be too disruptive to the global financial markets. Instead of rejecting the old standard, Wheatley asks for help in reforming it. His goal, in sum, is for international regulators and other industry participants to take pains to ensure that LIBOR and similar important benchmarks “are appropriately robust and credible.”
Now that Wheatley has submitted his recommendations for rehabilitating LIBOR, the U.K. government must formally endorse, modify or reject them. Financial Secretary to the U.K. Treasury Greg Clark has said that acting on Wheatley’s proposal is a priority and that he expects a formal response in mid-October, once Parliament has returned to session. In a public statement released immediately after Wheatley’s speech, Mervyn King, Governor of the Bank of England, reiterated his agreement with Wheatley's statement that LIBOR was “broken and in need of a complete overhaul” and said he supported the implementation of Wheatley’s recommendations as readily as possible.
The Wheatley recommendations make it more likely that a reformed, more empirically based LIBOR will emerge from the scandal. As Wheatley acknowledged in his report, however, some LIBOR rate submissions – as is the case with valuation generally – will continue to be based on “expert judgment” as opposed to actual market data. This, of course, leaves the door open for future manipulation. But if Wheatley’s recommendations are adopted, as they are likely to be, it is clear that would-be manipulators will face strong obstacles to, and stiff punishment for, manipulating the rate.
Perkins Coie has created a LIBOR task force to monitor the evolving U.S. LIBOR-related investigations and claims and to advise clients. Investors with questions regarding U.S. LIBOR-related claims should contact counsel to ensure that their concerns are addressed. Answers to Frequently Asked Questions about the LIBOR crisis, as well as ongoing updates from our LIBOR task force, are available online here.