The Death of Libor

Advanced reports are claiming that on Friday, the group that has investigated the Libor scandal will recommend that the British Bankers' Association (BBA) step down from its role as rate manager. The BBA has, in turn, said that it will step aside if the report makes that recommendation. If that happens, it will represent the end of an era in both British and global banking. The BBA has managed Libor for over 25 years, and in that time the rate has become an accepted standard. While the announcement hasn't come yet, it's fair to wonder, what's next?

The Wheatley report
The team looking into the scandal is being led by Martin Wheatley, managing director of the U.K.'s Financial Services Authority division of Consumer and Markets Unit. In the reviews' preliminary findings released last month, it found that the current self-regulated submission system was no longer viable and tentatively suggested that the Libor move to a transaction based system. That would mean that instead of submitting rates that individual banks thought they could get, they would submit the rates they actually received.

This would solve the fixing system, although many commenters have pointed out that it wouldn't be a cure-all. One of Libor's benefits was its constantly updated -- if false -- nature. Because some of the rates are not taken every day or by enough banks, then not every rate would be updated each morning. But setting that small hurdle aside, most of the more popular rates would be updated using actual market data.

The BBA's reaction
This is the entire reaction from the BBA to the news that Wheatley might call for a new system:

The BBA seeks to work with the Wheatley review team as they complete their consultation on the future of LIBOR. If Mr Wheatley's recommendations include a change of responsibility for LIBOR, the BBA will support that.

That's not a fight, that's the BBA rolling over. And why wouldn't it? Since Barclay's (NYSE: BCS  ) massive fine earlier this year, the name of almost every major bank from JPMorgan (NYSE: JPM  ) to Citigroup (NYSE: C  ) has been tossed around as being next on the chopping block. Those same banks make up the BBA, and you can bet that the members are ready to be as far from the scandal as possible from here on out.

But that leaves a gap that needs to be filled, and it's hard to guess who's going to step in to fill the oversight role. No government is going to want the added pressure of overseeing a new Libor, but even if one did step up, no one else would want a single government to have that much power. After seeing what a bunch of corrupt bankers were able to do, it's scary to imagine what could happen if crooked politicians got behind the wheel.

What comes next
Regardless of who takes the reins, Joanna Cound from BlackRock cautioned that banks need to "restore market confidence in Libor by evolution rather than revolution." That's because the Libor is used by so many markets that a complete revamp would throw the system into chaos, even if the change was as smooth as possible. The standard isn't just going to disappear into thin air, no matter what the most radical thinkers would suggest.

Instead, it's likely that the BBA will continue to manage the Libor in its current form for at least the next few months. At that point, some of the more common measures, like the three-month U.S. dollar rate, may well switch to a market data system. Those transactions occur often enough that they could be updated with new data every day. The rates that see less use would probably remain on the estimate system, but with more oversight from the FSA.

You can bet that as more banks are implicated, the BBA is going to work faster to get rid of its management position. Those banks are going to have hard times ahead, and I think that if enough are found with blood on their hands, we could be looking at a the beginning of the end for the post 1980s bank. With enough public outcry, or enough political pressure, the basic structure for oversight could change.

That uncertainty is keeping me out of bank stocks... for now. But there are smart people who disagree and think that uncertainty presents an excellent buying opportunity. Some Fool analysts certainly think that a few banks will get through unscathed, and they've authored a special, free report on The Only Big Bank Built to Last. If you're interested in dipping your toe in the banking water, learn more about the challenges facing the sector by getting your free report today.

Fool contributor Andrew Marder does not own any of the stocks mentioned in this article, but does have a small retirement account with Barclays. The Motley Fool owns shares of JPMorgan Chase and Citigroup. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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