SECOR's Scott Peng outlines how the inter-bank lending rate mechanism might be reformed.

Recent disclosures about practices at Barclays have shaken global confidence in LIBOR. But the fact of the matter is, LIBOR, as we know it, is broken and needs to be fixed, or else we risk long-term disruptions in the global financial system.

LIBOR is the average interest rate based on a daily poll of many large global banks that they believe they would be charged if they borrowed money from other banks. It is critical to the world economy because it serves as the benchmark for global interest rates and a variety of financial instruments. LIBOR stands at the centre of almost every floating rate loan made by banks to each other, to investors and to their clients. The accuracy of LIBOR is a matter of keen interest to everyone, from homeowners in Peoria, Illinois, to the largest companies in the world. 
LIBOR may be broken, but it can still be salvaged with some major structural changes. First, it should be redefined as a transaction-based rate rather than a poll based on theoretical transactions, as governor Mervyn King at the Bank of England has argued. There is strong precedence for this type of transformation. In the 1990s, the Federal Reserve restructured the CP (Commercial Paper) rate because the poll of market makers was not accurately reflecting transacted levels. While there was some disruption at the start of the changeover, the CP market adapted rapidly and embarked on a decade-long expansion.

Second, the short-term bank debt market LIBOR represents must be strengthened. At present, short-term bank debt is infrequently traded after issuance - most investors tuck them away until maturity. Market participants, regulators and central banks should join forces to foster a secondary market for the trading of bank debt that provides liquidity and price transparency.

A healthy secondary market to trade short-term bank debt will become increasingly important and necessary as Basel III is phased in globally.  Basel III's Net Stable Funding Ratio (NSFR) encourages the issuance of longer-term funding by banks while penalising short-term debt. Thus even a transaction-based LIBOR can have less relevance if it is based on decreasing issuance activity. The establishment of a viable secondary market for bank debt could strengthen LIBOR by providing a broader base of market activity for its determination.
A third and important structural fix for LIBOR and the short-term bank debt market would be a permanent bank-funding backstop. During the financial crisis, the US FDIC and the UK Debt Management Office set up programmes - the Temporary Liquidity Guarantee Program, or TLGP, and the Credit Guarantee Scheme, or CGS, respectively - to promote credit extension to banks via the issuance of guaranteed bank debt. These programmes should be made available to banks deemed "eligible and viable" on a permanent basis.
Under a permanent TLGP or CGS programme, banks could issue unsecured bonds when markets are normal. During a crisis, they could issue guaranteed bonds by paying an insurance premium to the insurance entity (FDIC or DMO) in return for the guarantee. A similar structure in Europe - perhaps with a guarantee by the new pan-European deposit insurance entity - could provide analogous help to European banks. The availability of high-quality, short-term bank debt via a TLGP/CGS-like programme during a market crisis would keep open the flow of credit to banks - and maintain the validity of LIBOR - while acting as a shock absorber to reduce the likelihood of a bank run.
Many who argue against a broad redefinition of LIBOR point to the potential impact on global credit markets and the $300trn notional of LIBOR-based derivatives market. It may indeed lead to higher costs for borrowers ranging from Fortune 500 corporations to students trying to fund their college education. Corporations and pension funds that hedge their liabilities via interest rate swaps also may be adversely impacted by a systematic adjustment.

However, the systemic risk to the financial system of doing nothing may be considerably greater. Confidence in the current framework will continue to ebb if additional rate-setting improprieties are uncovered. More banks will likely quit the LIBOR setting panel if the downside of their presence on the panels begins to outweigh the benefit. The decision to do nothing may lead to greater volatility and eventual irrelevance of one of the most important rates in the market. 
Today we stand at the crossroads of LIBOR's future. Implementing some or all of the steps described here would undoubtedly have a large impact on many aspects of global finance, but if we are successful in restoring its credibility, we may put the global financial system on a firmer footing for many decades to come. If LIBOR is not reformed, then we will need to find an alternative in short order. Gold anyone?

Scott Peng is a partner and head of global portfolio solutions at SECOR Asset Management