Why Finance Experts Are Rethinking LIBOR

Worldwide, as much as $350 trillion worth of financial products are tied to the London Interbank Offered Rate, or LIBOR. So it was no small concern this spring when some experts questioned whether the rate's daily updates were rigged to be artificially low. Set LIBOR rates too low and borrowers might get an undeserved windfall -- at lenders' expense.

"I think this is potentially a major issue," said Wharton finance professor Jeremy Siegel, adding: "We're talking about the biggest benchmark for short-term loans in the world." Wharton finance professor Franklin Allen said the process for setting LIBOR rates is "probably accurate most of the time. But some of the time it may deviate."

Questions this spring centered on whether some of the 16 banks that contribute data to the LIBOR calculation were reporting lower-than-actual figures to ease doubts about their own financial health. The first concerns were raised by some banking experts in April. Then, in May, The Wall Street Journal reported that its own study showed the LIBOR inexplicably diverging from what other interest-rate data suggested it ought to be.

Currently, the three-month LIBOR is around 2.7%, compared to 1.9% for three-month U.S. Treasury bills. The three-month LIBOR started the decade at more than 6%, fell to just over 1.1% early in 2003 and climbed to more than 5.6% last September before starting back down.

After doing its own investigation, the British Bankers' Association concluded at the end of May that there was nothing wrong with LIBOR reporting. But acknowledging the continuing concern, on June 10 it announced several procedural changes. Those include requiring member banks to justify rate discrepancies, increasing the number of banks it surveys and adding members to the committee that oversees the rate-calculation process.

Room for Improvement

"I don't think it's as accurate as it should be," said Mark Zandi, chief economist and co-founder of Moody's (MCO Quote - Cramer on MCO - Stock Picks) Economy.com, speaking before the June 10 announcement. "It's 16 financial institutions that are surveyed, 13 of which are in Europe. It's subject to the problems that small surveys have. It can be dominated by bad reporting by a few institutions."

On the other hand, he and others note that the 16 banks currently included in the survey include the world's biggest financial institutions. Barring deliberately inaccurate reporting, rates at which they borrow and lend should reflect the market. Siegel noted that banks would have little reason to low-ball rates for long, since that would reduce their earnings on loans tied to LIBOR. In effect, they'd be borrowing money at the higher "real" rate, and lending at a discount -- "shooting themselves in the foot," he said.

For non-experts there are some obvious questions: If there are doubts, why use LIBOR at all? Why not use an alternative that is beyond question, such as the going rate on U.S. Treasury bonds or some other index?

"It's not clear to me why U.S. homeowners should be paying a rate based on the cost of funds for European banks," Zandi said. Because some European banks have been hit hard by the credit crunch, loans tied to LIBOR now cost American borrowers more than they would if their loans were tied to some U.S.-based index, he said.

The British Bankers' Association launched the LIBOR in January 1986 as a way to closely track the interest rates paid by the banks that dominate the financial markets. The need for an accurate, frequently updated, internationally accepted gauge had become more and more acute as the financial markets became more global.

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