Jerome H Powell: Reforming US dollar LIBOR - the path forward
Speech by Mr Jerome H Powell, Member of the Board of Governors of the Federal Reserve
System, at the Money Marketeers of New York University, New York City, 4 September
2014.
* * *
Thank you for giving me this opportunity to speak this evening. I would like to discuss
ongoing efforts to reform the current structure and uses of the London Interbank Offered
Rate, commonly referred to as LIBOR. These reforms affect not only the financial industry,
but also a large number of U.S. households and corporations.
LIBOR is a reference rate. When two parties enter a financial contract in which interest
payments are to be exchanged, they frequently choose to base those payments on LIBOR.
LIBOR is currently referenced in roughly $300 trillion worth of contracts globally, which
means that it is part of the global financial system's critical infrastructure.1 But LIBOR's
credibility was badly undermined by the scandal that erupted when some of the banks that
help produce the rate attempted to manipulate it by contributing inaccurate estimates of their
borrowing costs. These illegal actions helped damage the public's trust not just in LIBOR, but
also in financial markets and institutions more broadly.
In response, a number of global efforts to reform reference rates have been undertaken.
LIBOR is produced and administered in London. As a result of the steps taken by the
government of the United Kingdom, LIBOR is now regulated and supervised by the U.K.
Financial Conduct Authority (FCA). The International Organization of Securities
Commissions (IOSCO) developed a broad set of 19 principles that reference rates and other
financial benchmarks are now expected to meet.2 Building on this work, in July, the Financial
Stability Board (FSB) released a report outlining a number of further reform proposals.3
Continuing the work of my former Fed colleague Jeremy Stein, I recently took over as
co-chair - along with Martin Wheatley, chief executive officer of the FCA - of the
international group that drafted the report and is now charged with implementing its
recommendations.4 Today I will discuss the reasons why further reforms are necessary and
how those reforms should proceed, and I will focus on U.S. dollar LIBOR.5 As is made clear
in the FSB report, while the goals and principles of the official sector participants are uniform,
specific plans for reference rate reform will vary by currency, depending on differences in
markets and institutions.
I will share my conclusion at the outset. While there have been significant reforms, much
remains to be done.6 First, U.S. dollar LIBOR needs to be updated to reflect current practices
in unsecured funding markets and to be better anchored in actual transactions. Second, and
equally important, regulators need to work with market participants to encourage them to
1
For more information on the role of LIBOR in the global financial system, see Wheatley Review (2012), The
Wheatley Review of LIBOR: Final Report (PDF) (London: HM Treasury, September).
2
Details on the principles may be found in Board of the International Organization of Securities Commissions
(2013), Principles for Financial Benchmarks: Final Report (PDF) (Madrid: Board of IOSCO, July).
3
For the FSB's reform proposals, see Financial Stability Board (2014), Reforming Major Interest Rate
Benchmarks (PDF) (Basel, Switzerland: FSB, July).
4
Former Federal Reserve Governor Jeremy C. Stein was the previous co-chair.
5
The views expressed here are my own and should not be taken to represent those of the FSB's Official Sector
Steering Group or those of the Board of Governors of the Federal Reserve System.
6
LIBOR reform and the work still to be accomplished are discussed in Wheatley Review, The Wheatley Review
of LIBOR, in note 1.
develop and adopt alternative reference rates that better reflect the current structure of U.S.
financial markets, in which borrowing and derivatives transactions are much more likely to be
secured with collateral. Going forward, these alternative rates could replace LIBOR as the
reference rate for new interest rate derivatives and some other contracts denominated in
U.S. dollars. These dual transitions will need to be managed very carefully to avoid disrupting
the financing markets on which borrowers and lenders depend. But I believe that they are
crucial to strengthening the stability of our financial system and to helping restore the public's
faith in its integrity. This problem is not just Wall Street's concern; every household with a
LIBOR-linked mortgage and every corporation with a LIBOR-linked loan has an interest in
more robust U.S. dollar reference rates.
The basics
I will take a few moments to explain the basic mechanics of LIBOR for those who have not
spent time on an interest rate swap desk. For almost three decades, LIBOR was run by the
British Bankers' Association. Just a few months ago, a private corporation called ICE
Benchmark Administration (IBA) took over the daily production and administration of the rate
subject to the regulation and supervision of the FCA. Today, 18 banks participate in the
panel that contributes to the production of U.S. dollar LIBOR. Each morning at 11 a.m.
London time, those banks estimate the rate at which they could borrow at several different
maturities ranging from overnight up to a year, and they send those estimates to IBA. It is
often the case that banks have recent transactions at some but not all of these maturities.
Where there are no transactions, they submit estimates of their borrowing costs based on
their judgment. In addition to U.S. dollar LIBOR, the rate is produced in four other currencies
- the euro, the yen, the British pound, and the Swiss franc - although not all banks contribute
rates in all currencies. The administrator provides specific instructions to the panel banks
regarding their submissions; currently, these instructions direct banks to reflect the perceived
rate at which they could borrow from another bank.7 The administrator collects these
submissions and, after dropping the highest and lowest quartiles at each maturity, publishes
an average of the remaining submissions as the U.S. dollar LIBOR rate for that day.
Pervasive and problematic
When the British Bankers' Association standardized LIBOR in the 1980s for use in interest
rate products, I doubt that anyone could have imagined how pervasive it would eventually
become. As I mentioned, there are an estimated $300 trillion in LIBOR contracts, roughly half
which reference dollar LIBOR. In the United States, dollar LIBOR is the reference rate used
in most interest rate swaps and futures contracts, in most floating-rate mortgages, in many
commercial loans, and in structured products such as mortgage- and asset-backed
securities. The list could go on and on, but the key point is that LIBOR touches a large
number of U.S. households and businesses.
Although LIBOR is currently used for all of these purposes, it is actually not ideally suited for
some of them. LIBOR is designed to measure the costs of bank borrowing for a panel of
large banks. The rate can be decomposed into a component that reflects the general level of
risk-free rates and a component that reflects a risk premium related to the credit risk of the
borrowing bank. During the global financial crisis, the credit risk component of LIBOR
fluctuated dramatically, which meant that LIBOR behaved quite differently from rates with no
credit risk embedded in them, such as risk-free rates.
LIBOR is a less-than-ideal rate for most derivatives contracts and secured borrowing
because movements in the credit risk component do not reflect well the underlying risks of
those contracts. However, LIBOR's pervasiveness has become self-reinforcing. Firms use
LIBOR in contracts, even when it is less than ideal, because they know they can hedge the
resulting risk using highly liquid, LIBOR-based interest rate swaps or other derivatives
contracts. And those derivatives markets are so liquid because most market participants use
LIBOR as the reference rate in their financial contracts. Because of the progression of this
dynamic over time, and not because of some careful design, LIBOR has spread well beyond
its intended uses and become an important pillar of the global financial system - perhaps too
important.
In recent years, two separate developments have called into question the wisdom of that
arrangement. I have already mentioned the first one - the emergence of a pervasive pattern
of attempted manipulation of LIBOR dating back many years. This misconduct was designed
either to increase the potential profit of the submitting firms or to convey a misleading picture
of the relative health of such firms. Since 2012, seven financial institutions have settled
related charges with the U.S. Commodity Futures Trading Commission and the U.S.
Department of Justice, and the cumulative penalties and fines paid in the United States now
stand at more than $3 billion.8 Global penalties paid related to benchmark misconduct
exceed $6 billion as investigations into reference rate manipulation continue. Although these
penalties and fines are themselves substantial, to my mind the longer-term damage to the
public's trust represents the greater cost of this misconduct.
A second problem is that unsecured interbank borrowing has been in a secular decline that
predates the global financial crisis. Changes in bank behavior following the crisis
exacerbated the decline and further weakened the foundation of LIBOR. The result is a
scarcity, or outright absence in longer tenors, of actual transactions that banks can use to
estimate their daily submission to LIBOR. Ongoing regulatory reforms and the shift away
from unsecured funding raise the possibility that unsecured interbank borrowing transactions
may become even more infrequent in the future. While it is also possible that activity in these
markets could rebound, the threat that this form of borrowing may decline further, particularly
in periods of stress, seems likely to remain.
So let me pose a question: Is it wise to rely on a critical benchmark that is built on a market in
decline? Clearly not. The risks to market functioning are simply too great. For example,
market activity could decline to the point where publication of a rate becomes untenable. And
many of the panel banks have expressed concerns about the ongoing legal risks of
remaining on the panel. If the publication of LIBOR were to become untenable or if we were
to simply "end LIBOR", as some have urged, untangling the $150 trillion in outstanding U.S.
dollar LIBOR contracts would entail a protracted, expensive, and uncertain process of
negotiating amendments to an enormous number of complex documents - a horrible mess
and a feast for the legal profession, to be sure. It does not help matters that the hundreds of
trillions of dollars' worth of derivatives contracts referencing LIBOR do not, in general, have
robust backups in the event that publication of a rate ceases.
The FSB report identifies ways to improve U.S. dollar LIBOR, and to create alternatives to it,
while minimizing transition costs, particularly for end users who bear no blame for the
misconduct. The proposed reforms come down to two simple ideas. First, U.S. dollar LIBOR
needs to be redefined to include a broader range of transaction types. Doing so will make it
more robust and will allow it to reflect actual bank funding costs, which is what the rate was
intended to do in the first place. Second, we need to promote robust alternatives to U.S.
dollar LIBOR that better reflect the secured nature of many of today's financial market
transactions.
Updating U.S. dollar LIBOR
Let me first address the efforts the Federal Reserve is considering, in cooperation with the
LIBOR administrator and U.K. authorities, to update the mechanics of U.S. dollar LIBOR. Our
aim is to make LIBOR more robust and more representative of current bank funding costs. In
this regard, we have considered two important attributes of LIBOR - its definition and the
data used to produce it.
While the current definition of LIBOR is limited to unsecured borrowing between banks,
LIBOR is actually intended to represent the overall cost of banks' unsecured borrowing. At
the time LIBOR was created, a substantial amount of that unsecured borrowing was in the
interbank market, but that is no longer the case. Broadening the definition to include the
unsecured borrowing from nonbanks would make the rate more representative of current
funding practices. Changing the definition of LIBOR, as has been done in the past, would
acknowledge the fact that a reference rate must adapt to continue to represent what it is
meant to measure.9
Updating the definition of U.S. dollar LIBOR could also allow other sources of transactions
data to be incorporated into it. Potentially, we could even move away from the current
panelbased method of calculating U.S. dollar LIBOR to a rate that is fully transactions based. In
April, the Federal Reserve began collecting data from banks on a variety of unsecured
transactions. These data, along with other available data, will help us understand whether
there is enough borrowing activity to support a fully transactions-based rate.10 It will take
some time to assess these data and, in particular, to analyze the depth of the markets under
different conditions and during different times of the year. But preliminary analysis, which is
reinforced by research done by the Market Participants Group (MPG) that was assembled by
the FSB, suggests that there may be enough borrowing activity to create a
transactionsbased U.S. dollar LIBOR rate.
Basing U.S. dollar LIBOR more on transactions could modestly increase the volatility of the
rate. However, I see nothing wrong with a reference rate that more accurately reflects the
volatility of the market it represents. We are working closely with the LIBOR administrator,
IBA, and with its regulator, FCA, to explore these issues. In this regard, cooperation with IBA
is crucial if LIBOR is to be strengthened - U.S. dollar LIBOR is produced in the United
Kingdom and is not regulated here in the United States. The IOSCO review found that IBA
has made progress in implementing most of the 19 IOSCO principles; the changes I have
discussed are designed to continue this progress, and I believe that IBA is well motivated to
continue its efforts.11
9
For a reference to a past change in LIBOR, see the British Bankers' Association's website "BBA LIBOR" at
www.bbalibor.com/disclaimer/explained/historical-perspective. The design of BBA LIBOR has seen one
significant change since its inception. Up until 1998, banks submitted quotes to the BBA LIBOR process in line
with the question "At what rate do you think interbank term deposits will be offered by one prime bank to
another prime bank for a reasonable market size today at 11 am?" During 1998, this question changed and
has, up until today, been as follows: "At what rate could you borrow funds, were you to do so by asking for and
then accepting inter-bank offers in a reasonable market size just prior to 11am?" This decision was made after
consultation with the markets and was implemented due to a view that a universal definition of a prime bank
could no longer be given. It also links the figures submitted by banks to their own market activity rather than a
hypothetical entity. For a reference to the usefulness of the adaptability of reference rates, see Board of
IOSCO, Principles for Financial Benchmarks, p. 12, in note 2.
10
For the report form used to collect these data, see Board of Governors of the Federal Reserve System,
FR2420, Report of Selected Money Market Rates (PDF).
11
The results of the IOSCO review are reported in Board of the International Organization of Securities
Commissions (2014), Review of the Implementation of IOSCO's Principles for Financial Benchmarks by
Administrators of Euribor, Libor and Tibor (Madrid: Board of IOSCO, July).
Alternatives needed
Improving U.S. dollar LIBOR alone cannot eliminate all of the weaknesses in the current
system. In the FSB's opinion and that of the MPG, a large portion of the derivatives that
currently reference U.S. dollar LIBOR would be better served by referencing a risk-free (or
nearly risk-free) rate based on a robust and liquid underlying market. These transactions are
more appropriately linked to a narrower measure of interest rates that does not include a
bank credit risk component. Encouraging alternatives that better reflect today's funding
markets would also allow for greater choice, increase the resilience of the system, and would
potentially make hedging of some risks less costly. In addition, the incentive to manipulate
LIBOR would be substantially reduced if a smaller share of the multi-hundred-trillion-dollar
derivatives market was referencing it.
Some possible alternatives include rates based on the U.S. Treasury market or rates based
on the secured funding markets that have replaced much of the borrowing banks used to do
in the unsecured interbank market. The Federal Reserve is not seeking to dictate the
particular rate that financial markets adopt. Instead, we will encourage key market
participants to further the work done by the FSB's MPG by narrowing down the list of
alternatives and developing them into robust reference rates that meet agreed-upon
international standards and best practices.12 There are enough suggestions on the MPG's list
to inspire confidence that we should be able to find common ground. Any alternative would,
of course, need to be in accord with the IOSCO principles mentioned earlier, and some
potential alternatives would take time to fully develop. But the establishment of alternative
reference rates for certain products is in our shared interests and would substantially
strengthen the financial system.
We are strongly committed that at least one such rate be developed and actively used as
soon as practicable. And we look forward to working with financial institutions and other
market participants to achieve this end.
In the near term, the Federal Reserve, along with other government agencies, intends to
meet with a wide range of market participants, including end users, to hear their views as to
how change can be effected and to begin the work of developing alternatives to LIBOR. Later
this year, we will convene a group of the largest global dealers to discuss these issues,
following a model that was successfully used to promote derivatives reform. Searching for
potential alternative rates and encouraging their use will be a key point of that discussion. Of
course, end users will be affected by these changes as well, and we will also consult closely
with key participants outside of the dealer community to make sure that reform meets their
needs and is not disruptive to them. In particular, end users who want to continue to use
LIBOR will certainly be able to do so, and we will work toward the goal of ensuring that any
changes to LIBOR will not require borrowers or lenders to amend their existing contracts.
And the markets that reference dollar LIBOR are so enormous that there will surely be more
than enough liquidity to support both a new risk free rate as well as LIBOR itself.
One of the lessons that I take from our study of LIBOR is that these existing legacy contracts
are quite important. As I mentioned earlier, many financial contracts, including derivatives
contracts, do not have robust backups in the event that the reference rates they use cease to
exist. Some derivatives, such as interest rate swaps, can be quite long lasting, and, over a
long enough period of time, there is always a risk that any given reference rate will cease
being published. It is important that financial contracts address the need for a backup plan if
a reference rate does cease to function. This issue is something that we intend to bring up
with market participants and end users as we meet with them.
Conclusion
My hope is that governments, market participants, and end users can work together to build
a stronger foundation for the reference interest rates that are so critical to our financial
system. Implementation of these measures is clearly in the interest of U.S. financial stability.
I also hope and expect that individual financial institutions will understand that it is also in
their private interests. Reference rates are one of the foundations of the financial system,
and it is in the interest of everyone, from the residential mortgage holder to the financial
institutions that heavily use these rates, that those foundations have integrity and be well
constructed and resistant to manipulation. As I said at the beginning, the problems with
LIBOR have undermined the public's trust in the financial system. In light of the need to
regain that trust, I am certain that our reform efforts will meet with the active cooperation of
financial institutions in carrying forward these reforms.