When the British Bankers Association issued a statement on Friday saying a key advisory committee did not plan to make immediate changes to how it calculates Libor, some officials hoped this might quell the current controversy about this crucial daily benchmark of money market behaviour.
Such hopes, however, seem naive. For while the BBA might have backed away from radical reform, unease about this benchmark remains high – not least because money market tensions are continuing to plague the system.
Consequently, bankers are now watching to see whether these frustrations will prompt some institutions to actively press ahead with creating alternatives to the BBA measure.
“The BBA’s announcement will certainly not quell the debate over Libor,” said Jeffrey Hogan, managing director of business development at BGC Partners. “The BBA did the market a bit of a disservice by raising expectations that there could be a change in how Libor is set, but the market needs to find a solution, not the BBA.”
The issue is particularly charged because the credit crunch has been marked by persistently large differences between overnight rates set by central banks and those quoted in the money markets.
More striking still, the rate of borrowing in Libor has lagged behind other market-based measures of unsecured funding used by the vast majority of financial institutions. This has aroused suspicions that the small group of banks which supply the BBA with Libor quotes have understated true borrowing rates so as not to fan fears they have funding problems.
The BBA said on Friday it would raise oversight of Libor, suggesting it will now check the banks’ quotes more closely. However, many observers want more radical changes – particularly in the dollar Libor index.
How cost of borrowing is calculated
Libor – which stands for London Interbank Offered Rate – reflects average borrowing costs in a group of banks. But this is not based on any actual deals; instead banks report to the British Bankers Association each day what they believe their borrowing costs to be.
The rate is calculated for 10 currencies, over multiple durations. Traditionally, it has been closely correlated to other money market measures. However, that relationship has recently broken down (see chart).
In the dollar market, investors have focused on the so-called TED spread, the difference between three-month Treasury bill yields and three-month Libor. Until August, Libor had averaged 30 basis points above bills for the prior five years. Between last summer and the end of April, this relationship averaged 139bp and late last week was at 79bp.
One key point of concern, for example, is that dollar Libor is being set in London before New York opens for business, where the bulk of dollar lending actually occurs – and of the 16 banks which supply the BBA with dollar quotes, just three are US based.
“This low US-domestic constituency on the Libor panel means that the majority of the banks on the Libor panel actually do not have full access to the full suite of the Fed and [other official] dollar-based liquidity programmes,” points out Scott Peng of Citi.
Given this, some bankers suspect the US market will start looking for alternatives. One idea being explored by groups such as Lehman Brothers is to develop the use of Overnight Index Swaps. Separately, ICAP is considering creating a New York-based measure of lending conditions.
“If, in spite of the Fed-ECB cross currency swaps, the demand by European and UK institutions for dollar funding remains elevated for a significant period of time, the creation of an alternate US index based on a poll limited to US depository institutions may be in order,” says Mr Peng.
Mr Hogan says: “There are reference alternatives avail-able now relating to OIS, Repos and Fed Funds which can become useful Libor complements in future.”
However, actually implementing these changes could be difficult, since a vast edifice of loans and derivatives are already tied to Libor. Barclays Capital, for example, says that nearly $2,400bn of loans tied to Libor are outstanding in the mortgage market – and likely to remain outstanding for several years. “Investors will probably end up using Libor swaps, flawed though they may seem,” said Barclays.
By Michael Mackenzie in New York and Gillian Tett in London |
