Libor rate faces shakeup as credibility is doubted


By Ben Livesey and Gavin Finch
Bloomberg News Service
Tuesday, May 13, 2008

LONDON -- The benchmark interest rate for $62 trillion of credit derivatives and mortgages for 6 million U.S. homeowners faces its biggest shakeup in a decade as lawmakers question if banks are understating borrowing costs.

For the first time since 1998, the British Bankers' Association is considering changing the way it sets the London interbank offered rate, according to Chief Executive Officer Angela Knight, who appeared before a parliamentary committee in London today. "We've put Libor under review," Knight said in an interview yesterday. The BBA will announce changes May 30, she said.

The BBA, an unregulated London-based trade group, sets Libor by polling 16 banks each day on the rates they pay for loans in dollars, British pounds, euros and eight other currencies. The association is under pressure to show the rates are reliable following complaints by investors that financial institutions weren't telling the truth after the collapse of subprime mortgages nine months ago contaminated credit markets and drove up borrowing costs.

While the BBA set the one-month dollar Libor rate at 2.72 percent on April 7, the Federal Reserve said banks paid 2.82 percent for secured loans later that day. Secured loans typically yield less than unsecured debt.

"The Libor numbers that banks reported to the BBA were a lie," said Tim Bond, head of global asset allocation at Barclays Capital in London. "They had been all the way along. The BBA has been trying to investigate them and that's why banks have started to report the right numbers."

... April Warning

Libor rates jumped after the BBA said April 16 that any member banks found to be misquoting rates will be banned. The cost of borrowing in dollars for three months rose 18 basis points to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze last August. The one-month rate climbed 14 basis points, its biggest gain since November.

The cost of borrowing in dollars for three months should be as much as 30 basis points, or 0.30 percentage point, higher than the current rate, Citigroup Inc. said in a report last month. Banks are understating borrowing costs on concern they will be perceived as "weakened" by the credit turmoil that forced banks to record $323 billion of losses and credit-markets writedowns, said Peter Hahn, a fellow at the London-based Cass Business School.

"Since the credit crunch, it's something that appears to have been manipulated," said Hahn, a former managing director at Citigroup. "We are in an extraordinarily delicate confidence time where a small event can shatter things quite easily."

... Review Brought Forward

The BBA accelerated its annual review of Libor to assess if there's a fault with how the rate is computed, if it reflects "difficult markets" or is "giving the right answer, just one that people don't want to hear," Knight said yesterday.

"Libor has stood the test of two decades," she said at today's parliamentary committee hearing. While the association has contacted all the member banks to investigate Libor "volatility," the swings in the rate are "hardly surprising" amid the credit turmoil, Knight said.

"We have not run away or hidden from the need for reform or the need for review" of "serious" issues in the U.K. financial-services industry, Knight said.

The BBA has submitted a report based on discussions with member banks to its independent Foreign Exchange and Money Market Committee, which is carrying out the review of Libor, said Brian Mairs, a spokesman for the BBA in London.

... BIS Report

The banking group, which represents Citigroup, HSBC Holdings Plc, and 14 other lenders, asks members each morning to say how much it would cost them to borrow from each other for 15 different periods ranging from a day to a year.

The Bank for International Settlements said in a March report some lenders were manipulating the rates to prevent their borrowing costs from escalating. The system still worked as it was meant to do as the credit crunch began in the middle of last year, the Basel, Switzerland-based BIS said.

Libor is used to guide banks in setting rates on most adjustable-rate mortgages. The prices they quote for credit default swaps are also linked to Libor.

"Libor is a proxy for the effective rates of the economy," said Rav Singh, an interest-rate strategist at Morgan Stanley in London. "Libor eventually feeds into the economy. There's so much on the back of the Libor problem. There are structured products, all the swaps, and then there are the hedging positions."

... Fed Action

To ease the credit crunch, the Fed cut rates seven times, created three lending facilities to help both banks and securities firms obtain funds and backed the takeover of Bear Stearns Cos., which was on the verge of collapse. In all, the central bank made more than $600 billion available to lenders and allowed Wall Street firms to borrow money overnight at the same so-called discount rate charged to commercial banks. Fed Chairman Ben S. Bernanke provided $29 billion of financing to back JPMorgan Chase & Co.'s bailout of Bear Stearns in March.

Bank representatives declined to say what recommendations they are making to change Libor.

HSBC and HBOS Plc spokesmen declined to comment. Deutsche Bank AG spokesman Ronald Weichert and Bank of America Corp. spokesman Scott Silvestri weren't immediately able to comment. Barclays, Royal Bank of Scotland and Lloyds TSB Group Plc declined to comment.

"I can confirm that along with the other 15 members of the BBA, as happens every year, we have been in consultations," said Richard Bassett, a London-based spokesman for WestLB AG. Rabobank Groep NV spokesman Anthony Arthur wasn't immediately available for comment.

Spokesmen for Mitsubishi UFJ Financial Group Inc. and Norinchukin Bank Ltd. weren't immediately available. A Royal Bank of Canada spokeswoman said it had discussions with the BBA as part of consultations with all Libor panel members and awaits the association's recommendations.

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