1. Importance of money market benchmark rates for financial stability and monetary policy
Statement by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank on the occasion of the public expert consultation of the German Bundestag's Finance Committee on 28 November 2012 on "Libor manipulation and other unhealthy developments in the financial industry"
Libor interest rates were established in the mid-1980s to provide a standardised interest rate benchmark for the (unsecured) interbank money market; since then, they have become an integral part of the financial system. They are particularly used as reference rates for a large number of derivative financial instruments. In addition, Libor rates are used as a benchmark for numerous loans with floating interest rates and for financial investments.
In the context of the tension observed in the unsecured interbank money market from 2007 onwards, the informative value of Libor and other benchmark interest rates used for the unsecured money market became the subject of a debate that gained further momentum recently with the emergence of details of the alleged attempted manipulations and led to prudential supervisory inspections of banks being carried out.
In the following, I shall draw attention to aspects that the Bundesbank deems to be important in the discussion on a reform of Libor and other money market benchmark interest rates from a financial stability and monetary policy perspective.
The integrity of money market benchmark interest rates is fundamentally important both for the correct pricing of numerous financial instruments, such as interest rate swaps and forward rate agreements, and for a large number of loan agreements that use these interest rates as a benchmark. Manipulations of these interest rates can cause considerable damage to both the real economy and the financial industry. Moreover, such manipulations can potentially impair the confidence placed in participants in the benchmark process and in the financial system as a whole. It is therefore vital, for reasons of financial stability, that benchmark interest rates are set using robust procedures.
Meaningful money market rates are useful from a monetary policy perspective as well: understanding the monetary transmission process and analysing the state of the money market are fundamentally important for monetary policy decisions. Analysing the effect of monetary stimulus is traditionally also based on unsecured money market rates such as Euribor, which is Libor's counterpart in the euro area.
Thus, meaningful and robust benchmark interest rates are in the interest of the Bundesbank for reasons of both financial stability and monetary policy.
2. Supervisory measures for reducing vulnerability to manipulation
The competent supervisory authorities (eg IOSCO, ESMA, EBA, BaFin), in particular, are currently considering numerous measures designed to reduce the risk of benchmark interest rates being manipulated. One measure being discussed is whether basing the calculation of benchmark interest rates to a greater extent on actual transactions might serve this objective. On the one hand, transaction data would be less vulnerable to manipulation and could be used by supervisory authorities as a starting point for reviewing the reported interest rates. On the other hand, non-transaction-based benchmark interest rates might be preferable as they can also be calculated in periods when there are few transactions, or none at all, in the underlying market segment, which can be the case in crisis situations.
Given that even a reformed model, eg one based on transactions, probably cannot fully disincentivise manipulations, it will be of prime importance to install appropriate governance and supervisory structures both at the level of banks (appropriate risk classification of the process, meaningful segregation of functions etc) and at the level of the institution that calculates the benchmark in question. In addition, it must be ensured that the institution that aggregates the data submitted by panel banks can actually accomplish its task in an independent manner. In principle, increasing the size of the panel of banks involved in setting the benchmark interest rates might also help to mitigate the risk of manipulation as a broader group of banks would make it more difficult to manipulate interest rates. Furthermore, one primary objective of any reform of the benchmark interest rate system should be the prevention of potential conflicts of interest.
For instance, it can be assumed that the incentive for institutions to submit incorrect data will be much less pronounced if they are not immediately penalised by the market for reporting "unfavourable" interest rates. In this respect, delaying the publication of interest rates submitted by the individual panel banks would be an improvement over the existing regime. In addition to the other considerations, the European Commission's intention to impose an explicit (sovereign) ban on the manipulation of benchmark interest rates as part of the future Market Abuse Regulation and Directive, combined with an effective threat of prosecution, also appears to be helpful.
3. Further options for reform from a central bank perspective
In parallel with the supervisory initiatives stated above, central banks are also discussing possible options for reform. The Bundesbank is a participant in these discussions. As part of the European Commission's public consultation on a possible framework for the regulation of the production and use of indices serving as benchmarks in financial and other contracts, the Eurosystem central banks have put forward proposals for Euribor reform which primarily recommend a more robust governance process and consider reliance on transaction-based figures. As part of this public consultation, the European System Risk Board, again with our involvement, has also submitted an opinion on macroprudential aspects of a reform of benchmark indices. Furthermore, a group of senior officials set up by the central bank governors represented in the Bank for International Settlements' Economic Consultative Committee, and in which I represent the Bundesbank, is currently addressing medium to long-term policy options for benchmark interest rates in the money market.
In the medium to long term, the use of alternative interest rates as benchmark rates is an option worth considering. Depending on how a benchmark interest rate is used in specific cases, repo interest rates could be used for benchmark purposes, for example. Repo rates reduce the counterparty risks included in Libor and Euribor largely on account of the collateral provided and provide a better reflection - at least they do at present - of the funding structures in the interbank money market. However, existing repo benchmarks are, in some cases, set in a similar manner to Libor and Euribor, or are not available for all the relevant maturities; additionally, differences in collateral quality impact on interest rate levels. Furthermore, it is important to consider that a general switch to differently structured interest rates might entail problems, given the heterogeneity and volume of existing contracts based on the benchmark interest rates used hitherto, and it could, for example, make it difficult to hedge obligations under these contracts.
The pros and cons of such proposals should therefore be given very careful consideration. In addition, the choice of appropriate benchmark interest rates is a matter for the private sector. Any transition to different benchmark interest rates should be at the discretion of the markets and not forced from above by legislators. Forcing actors to adopt a new system would constitute an intervention in the freedom of contract for which, in our opinion, there is no justification at this juncture.
Martin Wheatley's report on Libor, published in September 2012, estimates that the volume of financial contracts using Libor as their benchmark totals around US$300 trillion. See The Wheatley Review of LIBOR: final report, p 76.