LIBOR Is Neither Transparent, Nor Accurate, But Is There An Alternative?

The recent revelation that many banks, including Barclays PLC (LON:BARC) (NYSE:BCS), Royal Bank of Scotland Group plc (NYSE:RBS), Deutsche Bank AG (ETR:DBK) (FRA:DBK) (NYSE:DB), and others are involved in manipulation of LIBOR (London interbank offered rate), a benchmark rate used for setting the cost of borrowing around the world, raises questions on whether or not the hard earned money of the taxpayers is getting its true worth. The rate rigging scandal casts doubt about the reliability and accuracy of other key interest rates also, which are unanimously determined by the private sector, without much government intervention.

Every saving and loan rate, be it money market fund, short-term bond fund, or a small-business loan etc, is directly or indirectly related to LIBOR. In the US, LIBOR is used in nearly half of adjustable-rate mortgages and in about 70 percent of the futures market. Even some of the largest banks lend unsecured money among themselves on the basis of LIBOR. LIBOR was introduced in 1980, when lending and borrowing was common among banks.

After the 2008 global financial crisis, Downgrading of Banks, and the European crisis, banks are moving more towards secured borrowing. As Mervyn King, the governor of the Bank of England, said of Libor in 2008: “It is, in many ways, the rate at which banks do not lend to each other.”

With so much dependence on LIBOR, it is definitely worth asking why it is different from the other benchmark interest rates, like Euribor, or euro interbank offered rate, which is calculated in a similar way as LIBOR. For determining LIBOR, a bank is asked ‘what rate it thinks it can borrow’, and for Euribor the question is ‘rate it thinks other banks are able to borrow’. Despite following similar methods, Euribor for dollar borrowings is about twice as high as the comparable Libor.

Since 2008, LIBOR and other benchmark rates have been violating an important theory called interest rate parity, which says the difference in interest rates between two countries should be reflected in their respective exchange rates, if not it will result in arbitrage opportunity. LIBOR also deviates from other benchmarks on the volatility front also.  denominated LIBOR are less volatile when compared to similar benchmark rates.

These deviations certainly do cast doubts on the accuracy and integrity of LIBOR.

The ongoing rate rigging scandal clearly calls for a new and improved benchmark rate. A transparent and acceptable benchmark rate should be the one that is based on observable transactions. Something like overnight index swaps rate, which is used in overnight lending and borrowing among banks.