Global banking regulators are throwing in their two cents regarding possible reforms in the wake of the London Interbank Offered Rate (Libor) scandal.
The Bank for International Settlements (BIS) released a report Monday from a working group established by the Economic Consultative Committee calling for reforms by central bankers to help improve the use of financial market benchmarks. The report reviews issues in relation to the use and production of reference interest rates, such as Libor and Euribor, from the perspective of central banks.
In particular, the central bankers are worried about possible risks to monetary policy transmission, and financial stability, that may arise from deficiencies in the design of reference interest rates, market abuse, or from financial firms using reference interest rates that embody economic exposures other than the ones they actually want or need.
It finds that there’s an “urgent need to strengthen the reliability and robustness of existing reference rates and a strong case for enhancing reference rate choice,” it says. The report calls for prompt action by the private and the public sector to respond to these concerns.
In addition to the Libor market manipulation scandal, the report notes that a sharp contraction in market activity since 2007 has raised questions about the robustness and usefulness of reference interest rates based on term unsecured interbank markets; and, structural change in derivatives markets, such as the wider use of collateral and the move to centrally clear standardised OTC derivatives, may add to the demand for reference rates that do not embody bank credit risk.
“These developments and the current procedures that produce reference interest rates have potential implications for monetary policy transmission and financial stability,” it says. “From a monetary policy transmission perspective, reference rates may behave in unexpected ways especially in periods of stress. As a result, economy-wide financing conditions may change in unpredictable and unintended ways.”
As for financial stability issues, it says that a loss of confidence in reference rates, because they had been shown to be unreliable, could lead to market disruption. Poorly conceived reference rates could transfer risks in inappropriate ways, or they could transfer pricing errors across financial markets. And, unreliable reference rates may impair a central bank’s ability to respond to financial fragilities, it suggests.
To counter these risks, it calls for a sound rate setting process based on greater use of transaction data, combined with the transparent and appropriate use of expert judgment, to enhance the resilience of reference rates. And, it says that steps should also be taken to ensure contracts have robust fallback arrangements, in the event that the main reference rate is not produced.
Policymakers should agree on principles to strengthen governance frameworks that enhance the reliability and robustness of reference rates, it says. They should also work with the private sector to ensure adequate governance and rate setting, it notes. And, it calls for cooperation between central banks and regulators to enhance reference rates.
Additionally, central banks should promote additional choices in reference rates, it says, including encouraging a rebalancing away from current mainstream reference rates which embed banking sector credit risk, and to alleviate constraints on transition. In order to enhance reference rate choice, central banks can promote the development and improvement of (near) credit risk free reference rates such as overnight rates and overnight index swap rates or general collateral repo rates, it says.
“The report released today makes a significant contribution to the ongoing examination of reference rates used in financial markets. It is clear that central banks must play an important role in supporting the development of alternative reference rates,” said Mervyn King, chairman of the ECC and the current governor of the Bank of England.