Eideard

Daylife/Reuters Pictures used by permission

Governments in Europe, Japan, and the United States are now investigating 16 major banks for manipulating interest rates. In the months leading up to the 2008 financial crisis, many of the world’s most powerful financial institutions allegedly worked to keep down the London Interbank Offered Rate. Libor, as it is known, is supposed to be the average rate at which the largest and ostensibly safest banks in the world can borrow from one another. Manipulating Libor allowed traders to rig financial markets to their advantage; in the process, they distorted the actual value of key financial instruments such as credit default swaps, derivatives, and home mortgages.

The scandal has sparked calls from politicians, including Mervyn King, the governor of the Bank of England, for stronger regulation of the world’s most powerful banks. But such proposals miss a key point: Price fixing and manipulation are illegal. They have been for a long time. So it is unlikely that saddling financial markets with legal constraints that simply double down on what is already on the books will help. A better solution would go to the heart of the problem. Regulators and market participants should set such benchmark interest rates as Libor in a way that makes them reflect movements in the market, making manipulation impossible.

…Customers who borrow on a floating-rate basis…and institutions that loan money on a floating-rate basis…expect two things from a benchmark interest rate. First, the benchmark should reflect actual conditions in the financial markets. That means no random fluctuations — money costs what it is worth. Second, the benchmark rate should not be easy to manipulate. No rational, informed borrower would borrow money at a variable rate of interest and then empower the lender to determine when and how the interest rate changed in the future.

Even in the absence of manipulation, Libor is a poor market metric. Other benchmark interest rates, including the actual rates paid on U.S. government Treasury bills, notes, and bonds, make more sense…

So the Libor scandal is actually three scandals in one. The first is the way banks reported artificially low Libor rates to regulators. The second is the manipulation of Libor for trading profits. And the third is the use of Libor to determine home-mortgage interest rates when a better metric, U.S. Treasuries, was readily available…

In the world of financial contracts, rolling averages are generally considered the best reference point for adjustable rates. From the banks’ point of view, Libor’s advantage was the fact that it could be manipulated. But unless bankers want to hand over even more control to government regulators, they will need to restore integrity to and trust in the process. They need to drop Libor as the benchmark and replace it with an actual market rate.

RTFA. Jonathan Macey not only makes a great deal of sense, he provides the history to back up his suggestions. Of course, some of that history is criminal – and deserves punishment to fit the crime.