The Future of Libor Revealed

As predicted, the special investigation into the Libor scandal, run by the Financial Services Authority (FSA), came out this morning. Also as predicted, the broad recommendation was to relieve the British Bankers' Association (BBA) of its position and to hand that oversight over to the FSA. The more interesting parts came with the committee's recommendations about punishment for rule breakers, who sets the rates, and how many rates the Libor encompasses.

The two-minute version of history
The Libor is an internationally recognized rate, which represents the rate at which banks would be willing to lend to each other if they needed to borrow certain currencies over a certain period. For instance, the most popular rate is the three-month U.S. dollar rate. That's the rate at which banks could borrow money at if they needed U.S. dollars over a three month period. Simple.

Except, that's not really what it is. The Libor isn't the rate that banks actually get -- it's the rate they think they could get. That's why traders at Barclays (NYS: BCS) were able to manipulate it so easily, they just had to submit a different number, since there was no real system to check the validity of the number submitted. In fact, the whole rate setting team -- in charge of setting a benchmark rate for trillions of dollars in trades and loans -- consisted of two guys in a room at the BBA, with an Excel spreadsheet.

The author of the FSA's report, Martin Wheatley, said that that system is "broken and needs a complete overhaul," in part because it was "built on flawed incentives, incompetence and the pursuit of narrow interests." That led to the suggestion that someone else needs to give running the Libor a try, a suggestion that the BBA seems to be content with.

The fallout
Barclays was the first man down in the scandal, and the massive settlement helped fuel the need for a review of the whole Libor system. There's still more to come though, with JPMorgan (NYS: JPM) and Deutsche Bank (NYS: DB) among the organizations yet to receive a clean bill of health. But even before all the fines are handed out, the FSA is going to come in and make some changes. The biggest change is taking the Libor away from the BBA and having the FSA watch over it instead. This seems to be a temporary solution, though, with the long-term goal of having other organizations apply to manage oversight.

That fits with the general theme of all the recommendations, which can be summed up as more accountability with more input. In addition to giving a new group the reins, the FSA has recommended making Libor manipulation a criminal offense, with jail time for those who fiddle around. That's a big step forward, and something that the general public has been looking for in the financial world ever since the crash.

Instead of relying on people not to want to go to jail, the FSA also wants the new Libor to based on actual rates, instead of finger-in-the-air guesses. If you have to submit a real, traceable number, then it's harder to game the system. But that has a side effect -- the Libor is going to have fewer rates. Before the announcement, I thought that the FSA might suggest estimated rates for the lesser-used Libors and actual rates for the popular Libors. Instead, Wheatley has suggested dropping the total number of rates from around 150 to 20.

Opportunity knocks
Along with trimming the fat, the Libor might also include new rate submitters. Currently, around 20 banks submit their rates, depending on the rate in question. Under the new system, the floor would be open to adding more banks, in order to get a better idea of what the real rate was, and to make it so that no one bank could really sway a rate. In recently released documents from the Royal Bank of Scotland (NYS: RBS) , one trader emails another to announce that "[their] six-month fixing moved the entire fixing, hahahah." Those crazy guys.

It may seem like every major bank has been implicated in the scandal, but there are a few that stand out as clean. The most notable for U.S. investors is probably Wells Fargo (NYS: WFC) . The company is not a rate submitter to Libor and should stay clean throughout the process. But it doesn't mean that all is well. The impact of the rate change is going to ripple through almost every bank's book because of the mortgages and other loans that have been tied to the Libor.

There is one small bank that the Fool has identified that should be fine in the long run. This one has no direct connection to the scandal, and we think that value investors should definitely have a closer look. We've got all the details in our free report on The Stocks Only the Smartest Investors Are Buying. You can get your free copy today.

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Fool contributorAndrew Marderdoes not own any of the stocks mentioned in this article but, does have a retirement account with Barclays. The Motley Fool owns shares of Wells Fargo and JPMorgan Chase.Motley Fool newsletter serviceshave recommended buying shares of Wells Fargo. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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