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Corporate Jul 5, 2012

RBI should check if rigged Libor gypped our borrowers

By R Jagannathan

Can we trust our bankers - any banker? Ever since Lehman Brothers crashed in 2008, the world has been wary about big banks that are too big to fail. The fear is that they are greedy, they rig things to their benefit, but are largely unaccountable for the systemic damage they cause in the end.

This opinion is likely to be reinforced with the Barclays Bank scandal, where the bank has agreed to pay $453 million in fines to US and British regulators after the bank pleaded guilty to rigging inter-bank lending rates, the London Inter-Bank Offered Rate (Libor) in particular. Libor is an artificial, but indicative, rate set by the British Bankers' Association (BBA) based on the borrowing rates reported by its key banking partners. BBA represents over 223 banking members, but the big banks obviously carry more weight in setting Libor.

The question is this: shouldn't our own Reserve Bank of India (RBI), as India's banking regulator, be checking to see if Barclays and its Libor price rigging have damaged our interests in any way? But we will come to that a bit later. Let's start with what we already know about the Barclays case so far.

In testimony before UK lawmakers, Barclays' former CEO Robert Diamond, who quit in the wake of the scandal, admitted three things: that Barclays may have reported lower rates to the British Banking Authority (BBA) than warranted by its actual borrowing conditions; that fear of nationalisation after the Lehman crisis pushed the bank to indicate lower rates (the reasoning being that if Barclays reported higher borrowing costs, the government may think it is not able to raise capital and hence must be nationalised for systemic reasons); and that a current Deputy Governor of the Bank of England (BoE), Paul Tucker, who could well become the next Governor, had indicated to Barclays that there were concerns in the British government about the higher rates Barclays was reporting to the BBA. He apparently suggested, though in not so many words, that nothing would be amiss if Barclays reported lower interest rates.

All this would be nice drama for us to salivate over but for three important points.

If the Libor is an arbitrary rate and can be rigged so easily. Reuters

One, Libor is the basis on which over $800 trillion of borrowings and derivative instruments are priced all over the world. If Libor can be manipulated by phone calls and nudges and winks from the Bank of England, or for collateral purposes by the big clearing banks in the UK, the world would be right to consider it a rigged rate, and not one determined by actual market conditions. The world should sue BBA.

Two, India would be a particularly affected borrower due to this manipulation of Libor in the post-Lehman period. Big and small Indian companies that raise external loans in dollars or euro pay interest rates based on Libor. In fact, we always end up paying a huge premium over Libor most of the time. The RBI imposes an all-in cost ceiling of 200 basis points (2 percent) above Libor on trade credits and other loans upto three years. For external commercial borrowings (ECBs) from three to five years, and for loans above five years, the cost ceilings are 300 basis points and 500 basis points above Libor. Indian companies pay a huge price over and above Libor.

If the Libor is an arbitrary rate and can be rigged so easily, the RBI needs to take a close look at whether Indian companies have been gypped. Of course, they may also have benefited if Libor was artificially held down after Lehman, but for much of the time before that, there was no indication that rates were artificially lowered on a wink-and-a-nod. They could well have been higher. Question: did we pay more then?

Three, given the apparent risks in allowing so-called market rates to be set by participants who may or may not have vested interests, the RBI should take a close look at how rates are set even in India. Like Libor, the local inter-bank market has something called Mibor - the Mumbai inter-bank offered rate - which is calculated by the National Stock Exchange (NSE) based on the weighted average of reported bank lending rates.

According to The Economic Times, the NSE uses "robust statistical techniques" to confirm the veracity of the rates indicated by the big banks, and also eliminates the outlying rates to arrive at a mean that is broadly indicative of lending conditions on a day-to-day basis.

Thankfully, actual interest rates are not set by banks based on Mibor prices discovered through this way, but Mibor does play a role as a benchmark for influencing overnight interest swaps - which are derivative instruments that companies or financial institutions can use to migrate from fixed to floating interest rates or vice-versa, depending on their reading of how interest rates are headed.

This means Mibor may not be as influential as Libor, but it does have an impact on the costs for many institutions. For this reason alone, the RBI would do well to take a look-see at the NSE's way of computing the Mibor.

As for Libor, the RBI should meet its Bank of England counter-parts to discuss whether Indian corporates should ever borrow on the basis of Libor Plus rates, or instead be asked to borrow on the basis of different benchmarks that are not decided by interested parties.

The NSE structure, which has no vested interest in deciding or manipulating bank interest rates, seems better than the BBA one, where bankers as interested parties influencing the final rate on Libor.

This is how Libor (which incidentally is not one rate, but many, depending on currency, tenure, etc) rates are set, according to the BBA website, based on contributing panels of banks:

"Contributor panels comprise at least six contributor banks and broadly reflect the balance of activity in the interbank market. Individual contributor banks are selected by the BBA'sForeign Exchangeand Money MarketsCommittee - after private nomination and discussions with the Steering Group - on the basis of activity in the London market and perceived expertise in the currency concerned. Due consideration is also given to credit standing." (Emphasis ours)

"Contributed rates are ranked in descending orderand the arithmetic mean of only the middle two quartiles is used to formulate the resulting BBA Libor calculation for that particular currency and maturity. Individual contributor panel bank rates are released to the market alongside the Libor fixing each day, allowing market participants to view the rates that have contributed to that calculation along with the rate itself."

Quite clearly, this way of setting Libor (see how the BBA describes the process) is antiquated. Libor needs to be separated from its contributing banks and the BBA. The world should demand a change.

by R Jagannathan

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