The London Interbank Offered Rate (LIBOR) fixing has aroused widespread concern lately. Before we discuss the issue, let’s understand more how LIBOR fixings are compiled. LIBOR fixings, which are announced by the British Bankers’ Association (BBA) at noon on every trading day, are interest rate benchmarks gauging the costs of borrowing in the interbank market. LIBOR rates are compiled for 10 different currencies, and there are 15 borrowing tenors for each of the 10 currencies. Depending on the currency, there are seven to 20 contributing banks. As required by the BBA, the contributing banks have to report the rate they borrow funds denominated in a certain currency in the interbank market before 11:00 am each day. If a contributing bank has not conducted any such transaction prior to 11:00 am on a certain day, it will have to submit an estimate of its borrowing cost. Let’s take the one-month US dollar LIBOR as an example. There are 18 contributing banks. After receiving the quotes from the banks, the BBA will discard the four highest and the four lowest submissions and calculate the average of the remaining submissions, which will become the one-month US dollar LIBOR rate for that day.
There are similarities and differences between the fixing mechanisms of the Hong Kong Interbank Offered Rate (HIBOR) and LIBOR. Hong Kong dollar HIBOR is also based on quotes submitted by a panel of 20 contributing banks. These banks are active players in the Hong Kong dollar interbank market and are therefore highly representative. HIBOR is calculated by eliminating the three highest and the three lowest quotes and averaging the remaining 14 quotes. However, it is noteworthy that there is a fundamental difference between the definition of HIBOR and LIBOR fixings. HIBOR rate reflects the rate a prime bank has to pay for Hong Kong dollar interbank loans as estimated by the contributing banks while contributing banks for LIBOR are required to submit rates that reflect their own borrowing costs in the interbank market.
The LIBOR quotes submitted by the contributing banks daily are publicly available. As they reflect banks’ own borrowing costs, such quotes could carry a labelling effect. There are reports suggesting that some contributing banks deliberately understated their quotes, probably because the banks were worried about their reputation risk, given that their borrowing costs had risen alongside their deteriorated credit worthiness after they were adversely affected by the financial crises. On the contrary, under the HIBOR fixing mechanism, since the quotes by the contributing banks do not necessarily reflect their own borrowing costs, they are less likely to understate their quotes. Moreover, since the trading in Hong Kong dollar interest rate derivatives is not as active as the trading of US dollar interest rate derivatives, market participants believe that the incentive for HIBOR contributing banks to collude with each other to manipulate the fixings is much less than their counterparts in London.
Overall speaking, the HKMA has not observed any anomaly in the operation of the HIBOR fixing mechanism so far. Interbank lending for short tenors ranging from overnight to one week is still active while activities at the longer end have dropped markedly since the global financial crisis. Nevertheless, we have examined various financial instruments linked to Hong Kong dollar interest rates and have not observed any abnormal movements in HIBOR rates. The overnight and one-week HIBOR rates have stayed close to zero and the one-month and three-month HIBOR rates have stayed below 1% since 2009.
In fact, the difficulty faced by interest rate fixing mechanism stemmed from a reduction in interbank lending activities since the collapse of Lehman Brothers in 2008. Due to concerns about counterparty credit risk, banks become unwilling to provide unsecured longer term interbank loans. The consequential shrinkage of the interbank lending market led to the lack of actual interbank lending rates for reference. As a result, the contributing banks need to submit quotes based on their estimation. However, there are no clear guidelines for banks to follow when providing quotes in most markets.
Moreover, the definition of interbank interest rate fixing is not entirely clear. For most markets, the definition of interbank interest rates such as the Euro Interbank Offered Rate (EURIBOR) and the Tokyo Interbank Offered Rate (TIBOR) is similar to that of HIBOR. They are based on the rates prime banks have to pay when borrowing in the interbank market. However, as a number of major banks encountered financial difficulties and had to be bailed out by the governments during the global financial crisis, market participants have begun to question the definition of prime banks. In fact, LIBOR had the same definition prior to 1998. It was not until 1998 that the contributing banks were required to submit quotes based on their own borrowing costs. At that time, all contributing banks were prestigious banks and there was a high level of trust among them. Therefore the actual operation of the then LIBOR fixing mechanism was not very different from the interbank interest rate fixing mechanisms in other markets until the outbreak of the global financial crisis in 2008.
The troubled LIBOR fixing procedure has prompted various major financial centres to review their own interbank interest rate fixing mechanisms. As the credit risk premium for banks has been fairly small for long, interbank interest rates such as HIBOR and LIBOR have been viewed as stable reference rates. So, their fixings have been widely used as a reference for pricing a large number of loan contracts and interest rate derivatives. Should there be fundamental changes to the definition of interbank interest rate fixing, there would be far-reaching implications. This must be taken into account in the process of any review.
In response to the attention drawn to the HIBOR fixing process as a result of the LIBOR incident, the Hong Kong Association of Banks (HKAB) has initiated a review of the fixing mechanism and governance structure of HIBOR which have been in place for over 20 years. The review aims at enhancing the transparency and credibility of the fixing mechanism. In addition to making references to overseas markets’ experiences, the review will take into account recent changes in the interbank lending market and the potential impact on existing financial transactions and commercial contracts. The Treasury Markets Association in Hong Kong has established a working group to assist the HKAB in the review. The HKMA also supports the review and will monitor its progress.
Executive Director (Monetary Management)
3 August 2012