Global Economy: Settlement Exposes Underlying Weakness in Global Financial System but Offers No Solution

The London Interbank Offered Rate (LIBOR) and Euro Interbank Offered Rate (EURIBOR) are the benchmark interest rates used to set short term interest rates for over $10 trillion in loans – covering credit card rates, and car and student loans – and over $350 trillion in derivative financial transactions. The wide use of these rates was justified on the reasoning that they are not set by any one bank, there is no collusion between the banks that are surveyed for these rates and they reflect comprehensive analysis conducted by the world’s smartest bankers.

This theory makes sense because of how these rates are set: Thomas Reuters calculates LIBOR by surveying a panel of banks, eliminating the lowest 25 percent and calculating an average of the remaining 50 percent mid-values while EURIBOR is based on a survey of banks that are either based in the Eurozone or have large Eurozone operations.

While there have long been mumblings about problems with this system, problems came to the fore in June 2012 when Barclays Bank revealed collusion among the banks. The bank’s settlement included instituting steps to prevent such illegal activities and steps – based on recommendations by British regulators – have been taken but it’s unclear if they are either effective or comprehensive.

The recent $1.5 billion settlement between UBS and financial regulators further hurts LIBOR/EURIBOR’s credibility. This agreement is particularly significant because it shows this to be an industry-wide problem; the Barclay’s settlement was based on the assumption that individual bankers were plotting with other individual bankers to manipulate these rates. This scope is one reason why UBS’ settlement was three times larger than Barclays – on a negative note, it will likely be dwarfed by future agreements between regulators and other banks.

The question for us regular folks is what we can and should do regarding these illegal activities, which, unfortunately, isn’t much. We cannot stop using credit so we need to do something about the system either by replacing the use of LIBOR/EURIBOR through existing alternatives or creating a new system.

LIBOR/EURIBOR does have alternatives such as Repo, General Collateral Finance (GCF) and Overnight Indexed Swap (OIS) rates; the question though is whether they can fully compensate for the wide use of LIBOR/EURIBOR rates in the current system? Creating a new system, such as the one proposed by the CEO of Bloomberg comes with its own problems as it would need time to generate credibility with the markets. The only viable option, therefore, would be to clean up the current system, implement barriers and appoint gatekeepers that would ensure its legitimacy which would mean more legislation but that may not be a bad thing in this case.