LIBOR is fundamentally flawed and threatens London’s global position

This is a guest post by Financial Services Club alumni Professor Michael Mainelli:

One of the most famous security posters of the Second World War read “Loose Lips Sink Ships”. The idea was to curtail careless talk and prevent giving away information to the enemy. The Libor scandal has featured a different problem: too little careful talk.

The basics of the scandal are well-known. The British Bankers’ Association (BBA) provides a reference price for interbank offer rates. Under unclear oversight by the FSA and the Bank of England, at least one bank, but probably several, colluded in rigging submissions that established the reference price. The rigging has already been dated to at least 2007, but probably extends a few years earlier.

Numerous markets, including shipping and coal, use different methods to provide reference prices. In most. price fixing is a crime. Yet these prices are important and regulators sometimes relax policy to help price formation and aid overall competition. Although a number of methodological adjustments create Libor, like brute elimination of outliers, the method is not particularly sophisticated and fewer than 20 banks contribute.

Obviously, a big part of the problem with Libor is that banks don’t actually conduct transactions on these rates quite a lot of the time. Therefore, the BBA calculates a theoretical price rather than an actual willing buyer and seller price. But a bigger problem is that the BBA has failed to recognise that its theoretical price combines objective, quantitative factors with subjective, qualitative assessments. Radical overhaul is needed, incorporating more sophisticated statistical and mathematical techniques. This would provide better information and remove incentives to game the system.

For London, the Libor scandal is a severe own goal. Regulators appear to be both fools and knaves – fools in that they failed to uncover the problem until 2008, and knaves in that they failed to do anything about fixing Libor with any sense of urgency.

My firm publishes a semi-annual Global Financial Centres Index. Since the first compilation in 2005, London has held the top spot, followed closely by New York. Hong Kong and Singapore have since risen to join as “global financial centres”, principally due to the rise of Asia and the quality of their regulation. Being a leading global financial centre is a valuable prize that should be defended through institutions and culture. Scandals as crass as Libor should never happen.

The two top areas of financial centre competitiveness are quality of people and business environment, particularly regulation. Before the financial crises, people were paramount. Since 2008, business environment has become most important.

However, one crucial aspect of financial centre competitiveness is hard to express. For a financial centre to be attractive to foreign businesses, it has to be perceived as being fair to foreigners. Fairness is signalled in many ways: ease of market entry, justice in courts, equal taxation. Fairness is also found in market structure. Foreigners tend to enter markets where there is no dominant advantage to the local players and there are numerous examples of competitors thriving. Ultimately, a global financial centre’s hold comes down to feeling and trust, as much as pure financial logic.

The Libor scandal makes London look as if foreign business isn’t treated fairly. There will be cries that overseas banks were involved and that Bob Diamond is an American. But this scandal gives the impression that London’s core financial community is still an old boys’ club, which is terrible for trust.

As such, London shouldn’t be surprised to see strong attacks from Libor rivals. That said, given that Eurobor and others use similarly flawed methodologies, they also need to change to be seen as fair.

The need to relaunch, rather than fix, Libor is urgent. We need a strong signal to show that London is open for business for anyone prepared to accept fair regulation. Changing Libor will be a Herculean task, given how fundamental it is to so many contracts. But a fundamentally reassessment of its methodology is still urgent, even if it will likely lead to higher rates and numerous litigation issues.

The problem here is not the mental capacities of regulators in the Bank of England. We just need to start talking openly about radical changes that will prove London is a jurisdiction where everyone is treated fairly.

Professor Michael Mainelli is executive chairman of Z/Yen Group and this article was first published in CITYam.