A global probe into whether banks colluded to set the interest rates at which they borrow money from each other has thrown into question the future of the benchmark they use to price financial products worth an estimated $360 trillion.
This intense scrutiny has prompted the British Bankers' Association (BBA), which establishes the parameters for the benchmarks, to hire consultants to ensure the rates are fit for purpose, a source familiar with the process said.
But despite widespread concerns about the way Libor (the London Interbank Offered Rate) is set, it remains at the heart of the financial system and is used to price anything from corporate loans to residential mortgages.
The BBA told Reuters the design and operation of Libor was under continual review and scrutiny by the independent board and committees that govern it.
"These bodies, from time to time, engage reputable professional services companies to ensure their work is carried out thoroughly and to the highest standards," it said in a statement. The trade body declined to comment further.
Like the credit ratings agencies whose role has been under fire both during and after the initial stages of the financial crisis, there are few credible alternatives to replace a system many now regard as outdated and discredited.
The BBA has watched with growing concern how Libor, designed in the 1980s to estimate the costs at which banks lend to each other, has become the key benchmark for anything from derivatives contracts in London to commodity trading in Chicago.
If Libor is found to have been distorted or manipulated it would cast doubt on every contract that has used it as a reference point. The first legal cases have already been brought, but these may not have much impact unless criminal wrongdoing can be proven.
"You are clearly going to get something more concrete from a judgement in criminal or civil proceedings than from a typical FSA (Financial Services Authority) enforcement action if you wanted to mount proceedings for recovery of losses," said Michael McKee, financial services partner at law firm DLA Piper.
Doubts about the way the rates are decided arose during the worst of the financial crisis, when Libor remained relatively low despite the fact that the interbank market it is meant to represent had dried up, with banks too scared to lend to each other.
In March 2008 the Bank for International Settlements said some banks might have submitted inaccurate Libor rates to keep borrowing costs from rising, later saying that in some circumstances contributing banks may have deliberately disclosed biased quotes.
"The BBA recognised that this needs to be looked at," said the source, who spoke on condition of anonymity. He expects the BBA to publish a statement on its conclusions around the end of the first quarter.
"I think they will define the purpose of Libor and then come up with a caveat -- that if people use it for more, on your own heads be it. So there will be legal as well as economic and financial elements."
International enforcement agencies have been trying for more than a year to establish whether banks colluded in London and beyond, and whether traders used this inside information to profit from trades.
The rates are compiled and distributed for the trade body each day by global news and information provider Thomson Reuters .
"Thomson Reuters continues to calculate and distribute LIBOR on behalf of the BBA, in accordance with its governance procedures and will support the BBA should any changes be recommended." the company said in a statement.
CRACKDOWN AT BANKS
As enforcement agencies from the United States to Europe and Japan continue their probe, sources said banks such as JPMorgan , Deutsche Bank, RBS and inter-dealer broker ICAP have already seen staff either leave or be fired. All three banks declined to comment.
ICAP has suspended one employee and placed two more on leave in recent weeks, according to one source, who spoke on condition of anonymity. The broker, which said in November it had received requests from government agencies for information as part of the investigations, also declined to comment.
Royal Bank of Scotland declined to comment on an ongoing court case in Singapore involving a former trader who is suing the bank for wrongful dismissal after it alleged he had improperly influenced interbank rates.
Libor is designed to reflect the likely rates at which top banks believe they could borrow money from each other each day in 10 major currencies and for 15 borrowing periods ranging from overnight loans to 12 months.
Some traders said Libor dollar rates were quoted as much as 150 basis points below "market" rates in October 2008 when, in the wake of the collapse of Lehman Brothers, banks struggled to convince markets about their creditworthiness.
"In late 2008, we saw that the actual funding cost of banks was at a completely different level than what was indicated by Libor," said one Norwegian dealer, who declined to be named. "It was a particularly bad time in the funding market with real costs at least 150 basis points above the official fixing."
One senior banker told Reuters that Libor had long been a flawed benchmark, and that it was easy for banks to see that it was not representative of the true rate at which they lent or borrowed during the financial crisis, and even now.
He said he had thought banks would move to a cost-of-funds principle to set price levels in areas such as the corporate loan market, where a margin for risk would be applied above banks' true funding levels rather than Libor.
As early as September 2007, Wrightson, the research arm of interbank brokerage ICAP, reported allegations by market participants that one-month Libor was being under-quoted relative to actual borrowing rates.
Basel-based BIS, which acts as a central bank for the world's monetary authorities, said the BBA's procedure of stripping out the highest and lowest bank estimates before calculating the rate - a process called "trimmed means" - minimized any possible manipulation.
But it said the system was not foolproof.
"Even trimmed means can be manipulated if contributor banks collude or if a sufficient number change their behaviour."
Since the 2007 allegations, about 12 major banks have been subpoenaed, the first lawsuits against banks are winding their way through courts in the United States and Europe, and the BBA last year expanded the panel of banks that contribute to the Libor rate in dollars to 20 from 16.
Some are making efforts to establish alternatives.
ICAP, the biggest broker of transactions between lenders, has set up the New York Funding Rate, which is based on an anonymous daily survey of at least 16 banks.
NYSE Euronext's Liffe derivatives contracts have also started including futures based on an overnight interbank borrowing rate calculated by the European Central Bank.
And last June, the Wholesale Markets Brokers' Association launched a new reference rate called the Repurchase overnight index average, which is based on actual money-market deals.
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