By Kermit Schoenholtz, Professor of Management Practice and Director of the Center for Global Economy and Business, and Lawrence White, Robert Kavesh Professorship in Economics and Deputy Chair of Economics
The recent revelations by Barclays Plc (BARC) probably spell doom for the London interbank offered rate, at least in its present form.
Many banks facing huge legal risks could decide to end their participation in the rate-setting process. And even if most institutions remain involved, Libor needs fundamental reform if it is to restore its credibility as a benchmark for hundreds of trillions of dollars of financial contracts.
How to ensure that a damaging scandal won’t happen again? The answer seems straightforward: Wherever feasible, benchmarks for financial contracts should derive from actual transactions, not surveys, as is the case with Libor.
The current “survey Libor” is an old-school model that can’t endure. Each day, a group of banks -- 18 for the U.S. dollar panel -- submit to the British Bankers’ Association the hypothetical interest rate at which they believe they could borrow from other banks. To determine the rate, the BBA disregards the top four and bottom four responses, and averages the remaining 10.
Read full article as published on Bloomberg.