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Four fixes to the Libor scandal

July 23, 2012: 11:36 AM ET

Now that we know what happened with the banks and Libor, what should we do to prevent it from happening again? Four options for reform or regulation, some better than others.

FORTUNE – Investigations and talk of reform are dominating the headlines about the rate-fixing scandal tied to the London Interbank Offered Rate, or Libor. The interest rate influences many aspects of the world we live in, from Spanish and U.S. mortgages to derivatives contracts in London.

Since as early as 2008, policymakers have acknowledged the process by which Libor is calculated is imperfect. And London-based Barclays' recent settlement over interest rate manipulation has confirmed what many of us had suspected on Wall Street and the rest of the finance world: Something corrupt could be going on.

In September, central bankers are expected to gather for a meeting on the possible future of Libor. Fortune takes a look at four fixes that many policymakers and investors are talking about. What are the options – could Libor be reformed, or should it be replaced?

1. Leave it to the government

If leaving it to the banks has left Libor exposed to manipulation, might the government help clean things up?

Currently, the British Bankers Association, a private industry group, oversees the process by which Libor is set. But U.S. Federal Reserve Chairman Ben Bernanke warned last week that the system is structurally flawed.

MORE: Barclays the biggest Libor liar? No, that may have been Citi

The European Central Bank could be best positioned to police Libor. It already sets Eonia, an overnight lending rate that helps control inflation. As Reuters notes, unlike Libor and Euribor, Eonia is based on actual transactions by a panel of banks rather than estimates that leave the rate exposed to collusion. To be sure, the Barclays settlement includes more government oversight of the bank. It not only orders the bank to base its Libor submissions on market prices rather than estimates of borrowing costs, but the settlement also calls an independent auditor to scrutinize its submissions for the next five years and report back to the Commodity Futures Trading Commission.

But even if government plays a more active role monitoring Libor, it still might not solve the problems of the system. As The New York Times notes, Libor seems inherently dysfunctional. Even if the rate were based on actual transactions, those aren't easy to come by, as many banks in recent years have been reluctant to lend to each other.

What's more, judging by previous warnings, it's uncertain how helpful government would be. As a slew of documents released last week revealed, in 2008, U.S. Treasury Secretary Timothy Geithner, then head of the New York Fed, pushed the Bank of England to reform Libor after hearing from traders that bankers were deliberately understating the daily rates. Needless to say, reforms didn't go far enough.

2. Leave it to the markets

As policymakers argue that Libor is inherently imperfect, might it be better just to do away with the benchmark altogether?

Not only has the Barclays settlement exposed the fact that Libor is derived from estimates rather than real market data, but the way the final rate is calculated is further flawed by evidence that banks have mostly stopped lending to each other.

Bernanke and global financial regulator Mark Carney, who is also governor of the Bank of Canada, have suggested the idea of using repo rates, the rate that financial institutions charge each other for short-term loans.

The benefit of such rates is that they're based on actual market transactions. And some banks have reportedly been testing a rate linked to the market for repurchase agreements.

However, as Bernanke and others have noted, Libor will be difficult to replace as a market benchmark simply because investors are so accustomed to it (Libor has been around since 1986). And while repo rates are thought to provide more accurate borrowing costs, that may be less so given, as The Wall Street Journal notes, that collateral such as Treasuries are used and therefore are less risky than loans in the Libor market.

3. Go auction-style

Many of the problems in calculating Libor are also evident in auctions, as The Economist recently pointed out. And so it might make sense to apply some of the checks that go on at auctions to correct flaws in Libor.

Traders have been accused of colluding when coming up with the benchmark. This isn't helped by the fact that the BBA makes individual estimates public and so it's relatively easy for traders to peek at what others have done to influence the final rate. This is similar to those of bidding rings formed at auctions.

MORE: Wall Street's latest sucker: Your hometown

To help clean up Libor, the BBA could penalize traders giving false estimates, just as auctions have penalized those giving false bids. What's more, to increase chances of accuracy, the trade group could increase the number of banks reporting rates and keep those private.

4. Give Main Street some justice

Perhaps the ultimate fix would be to send Wall Street a clear signal that messing with Main Street is simply unacceptable.

The Libor scandal has brought about a class action lawsuit that alleges that banks including Barclays (BCS), Bank of America (BAC), HSBC (HBC), JP Morgan (JPM) And UBS (UBS) conspired to fix Libor, costing cities millions of dollars in the process. Baltimore is the lead plaintiff in the suit, with Mayor Stephanie Rawlings-Blake taking on Wall Street's shady dealings, arguing that firefighters, services for the elderly, school programs and other public services have suffered budget cuts as a direct result of actions of colluding bankers.

This isn't the first time Baltimore has stood up against Wall Street. The city launched a lawsuit against Wells Fargo (WFC) four years ago that alleged the bank discriminated against black and Latino mortgage borrowers. That case was settled earlier this month in a $175 million settlement, but it's uncertain if justice has really been served. After all, the bank, like too many others faced with similar suits, admitted no wrongdoing.

To be sure, former Barclays CEO Bob Diamond and other key executives resigned after the bank was tacked with a $450 million fine for attempting to manipulate Libor. And as Reuters reported Monday, U.S. prosecutors and European regulators are near arresting individual traders and charging them with colluding to manipulate interest rates. It remains to be seen what happens with these cases. While the investigations suggest that serious charges against banks could unravel soon, perhaps the proper fix is if other banks besides Barclays acknowledge they've been doing something very wrong.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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