Strat. Change 23: 119–124 (2014)Published online in Wiley Online Library(wileyonlinelibrary.com) DOI: 10.1002/jsc.1964 RESEARCH ARTICLE

Copyright © 2014 John Wiley & Sons, Ltd.Strategic Change: Briefi ngs in Entrepreneurial Finance

Strategic Change DOI: 10.1002/jsc.1964

LIBOR, EURIBOR, and the Regulation of Capital

Markets: A Review of the Effi cient Markets Hypothesis1

Marianne OjoSchool of Economics and Decision Sciences, North-West University, Mmabatho, South Africa

Introduction

Pressures for the deregulation of national capital markets have increased over the years in response to global liberalization processes. Th e diff erences in the levels and extents of regulation of capital controls that operate within national borders have aff ected in various ways the competitive positions of banks in external markets.

Th e growth in international fi nancial markets is due only in part to multiplier mechanisms. Some basic characteristics of off shore contexts — such as the Euro-dollar market, featuring freedom from national regulations and international scope and dimension — have also contributed signifi cantly to the popularity and attrac-tiveness for investors. Indeed, a huge quantity of resources has migrated from onshore to off shore destinations notwithstanding the associated additional risks in taxes, various diffi culties in accessing those particular markets, as well as incon-veniences arising from foreign deposits.

Th e developments that have dominated the liberalization of fi nancial markets stem from the rise of the Eurocurrency markets in the 1960s and the subsequent shift from banks to portfolio investment in the 1980s. As D’Arista (2002, p. 77) has eff ectively pointed out:

Th e waves of capital fl ows into the United States, and subsequently into Germany, Switzerland, and other European countries in the late 1960s and early 1970s, demonstrate how eff ectively the Eurocurrency markets are able to circumvent capital controls by making it possible for participants to change the currency denomination of loans and investments outside national markets in response to changes in interest rates, and subsequently (to) changes in exchange rates.

The liberalization of global and

external capital markets has

provided the impetus and

justifi cation to deregulate

national capital markets.

The need and concern for

increased regulation of bond and

equity markets, as well as other

complex fi nancial instruments

which can be traded ‘over the

counter’ in the derivatives

markets, is evidenced by Basel III’s

focus.

‘Cartelization’ and organized

activities in global capital markets

have been evidenced recently by

sophisticated EURIBOR and LIBOR

rate-rigging practices and

occurrences.

The recent rate-rigging scandals serve as a reminder that capital markets need to be

properly regulated.

1 JEL classifi cation codes: D53, E44, E52, G01, G12, G15, P43.

120 Marianne Ojo

Copyright © 2014 John Wiley & Sons, Ltd. Strategic Change DOI: 10.1002/jsc

Th e Eurocurrency markets have not only facilitated the undermining of regulatory strategies given their ability to circumvent national capital controls and regulations, but also hindered the central banks’ ability to implement monetary policies eff ectively. A further and more lethal consequence has also emerged over the years: the rigging of the London Inter-Bank Off ered Rate (LIBOR) and Euro Inter-Bank Off ered Rate (EURIBOR).

Defi nitions

LIBOR is described as ‘the benchmark interest rate that underpins trillions of loans, credit cards, mortgages and derivatives around the world’ (Merco Press, 2012), while EURIBOR is also considered of vital signifi cance given its role in setting borrowing rates for trillions worth of mort-gages, loans, and credit cards. Philipponnat (2012) has noted

LIBOR and EURIBOR have diff erent defi nitions, which makes the possibility of rate rigging diff erent. However, they have one feature in common: they are calculated from contributions with in-built confl icts of interest and this characteristic is not compatible with the ambition of rebuilding integrity and trust in our fi nancial system.2

While LIBOR is considered to ‘refl ect the cost of borrow-ing of the contributing bank,’ EURIBOR ‘refl ects the contributing bank’s conviction about the cost at which a prime bank (i.e., not necessarily the contributing bank itself ) would off er term deposits to another prime bank’ (Philipponnat, 2012). Furthermore, LIBOR is ‘the average rate at which a leading bank can obtain unsecured funding in the London interbank market for a given period, in a

given currency’ (Treasury Today, 2012).3 Th e ways whereby corporations are exposed to the two rates include borrow-ing and their use as reference rates in many derivative products and swaps. At present, LIBOR and EURIBOR have, respectively, 18 and 44 contributing banks.

Self-regulation

Th e self-regulatory nature of LIBOR is illustrated by the fact that ‘it is not only currently presided over by the British Bankers’ Association (BBA), a private banking trade and lobby group,’ but also indirectly by 18 of the world’s largest banks, ‘which submit loan data to the Libor board every morning to help set the global rate to which their own trading bets are tied’ and control, at the same time, the BBA itself.

As a result of the self-regulatory nature of LIBOR, regulatory capture not only constitutes the inevitable con-sequence but also the frequent occurrence of practices attributed to a system void of adequate levels of account-ability and transparency, as well as one embroiled in asso-ciated corrupt practices and confl icts of interest. Lack of accountability facilitates an environment whereby high degrees of confl ict of interest are encouraged. It also facili-tates incidences involving the ‘passing of the buck’, which results in an inability to identify and bring to book the principal off enders. Several sources contend that the rigging of LIBOR and EURIBOR scandals commenced as far back as 2005, culminating during the last worldwide fi nancial crisis. Even though concerns and suspicions of rate-rigging practices had been raised as far back as 2007, these expressed concerns remained unheard and the rate rigging has escalated to the levels that presently persist.

2 Philipponnat (2012) adds that the diff erent defi nitions of EURIBOR and LIBOR rates refl ect the fact that they were established by diff erent private bodies pursuing diff erent and often competing interests.

3 It is also to be noted that ‘it is a lending (off er) rate, not a deposit (bid) rate, and is calculated by averaging the middle two quartiles of the rates submitted on a daily basis by a panel of 16 banks to the BBA (British Banking Association). Th e top and bottom quartiles are discarded’ (Treasury Today, 2012).

LIBOR, EURIBOR, and the Regulation of Capital Markets 121

Copyright © 2014 John Wiley & Sons, Ltd. Strategic Change DOI: 10.1002/jsc

As stated by Philipponnat (2012):Benchmarks with a large public impact should not be

left purely to private interests. Th e idea of ‘eff ective self-regulation’ has proven over and over again to be an oxy-moron in fi nancial services and is not the way to restore the public’s profoundly shaken trust in the fairness of fi nancial activities.

Recent discoveries not only reveal that a group of international banks have been manipulating interest rates for years (see, for example, Böll et  al., 2012), but also point to the even more serious fact that some banks involved in the cartelization process are those responsible for setting and calculating the LIBOR rates. Whilst two traders have recently been made scapegoats for the regula-tory failures and gaps in the rate-rigging process,4 it is becoming more likely that other participants in the rate rigging (bankers included) will be placed under pressure to disclose their involvements in the cartelization process.

Recent measures and proposals

LIBOR’s fi xing imposes more requirements than that of EURIBOR, whereas the number of banks contributing to the EURIBOR determination makes it less likely for manipulating practices to occur. Greater accountability will be achieved if the number of banks contributing to the determination of LIBOR rates increases. Greater con-sistency can be achieved with the defi nitions of the two reference rates by basing them on eff ective fi nancial rates, whilst more accountability can also be fostered by making banks, managers, and operators individually and collec-tively responsible for their actions.5 Furthermore, external

regulatory oversight of benchmark setting, as well as greater use of transaction data, has been put forward (Finance Watch, 2012).

Th e impact of LIBOR and EURIBOR on millions of lives was clearly illustrated in the interpretation of Grey (2012):

Th e daily Libor rate, which is supposed to measure the average cost of short-term loans between major banks, determines the interest rates for loans and investments that aff ect hundreds of millions of people around the world. Libor and Euribor are used to set the borrowing rates for $10 trillion in mortgages, student loans and credit cards. Some 90 percent of US commercial and mortgage loans are said to be linked to the index. Libor infl uences an estimated $360 trillion of loans and credit default swaps. It impacts futures contracts traded on the Chicago Mercantile Exchange with a notational value of more than $564 trillion.

It would therefore not only be in the public’s interest, but also in the interest of global and economic stability (and a means of restoring the credibility of the LIBOR and EURIBOR rates on which many investors and markets rely), if measures and reforms aimed at addressing the rate-rigging practices could be implemented eff ectively.

Monetary setting policies

Th e impacts of Eurocurrency markets on monetary setting policies and banks’ competitive positions have also been highlighted. How can regulation be implemented eff ec-tively to ensure that it is not too rigid (such as to place banks at competitively disadvantaged positions in external markets) while not being too lax (such that eff ective moni-toring, compliance, and enforcement mechanisms are impeded)?

In addressing the issue of monetary policy setting, the challenges faced by the US Federal Reserve embrace the admission that current fi scal and monetary policies in the USA are not feasible, as well as the argument that the

4 Th e Swiss Competition Commission has recently declared: ‘Derivatives traders are also believed to have agreed upon the diff erence between the buy and sell prices (spreads) of derivatives, thereby selling these fi nancial instruments to customers under conditions that were not customary in the market.’5 As well as making contributions refl ect fi nancial reality, basing LIBOR and EURIBOR on eff ective rates is also said to narrow the avenues whereby rate manipulation could occur.

122 Marianne Ojo

Copyright © 2014 John Wiley & Sons, Ltd. Strategic Change DOI: 10.1002/jsc

Federal Reserve’s range of powers is too wide.6 Th e Federal Reserve is considered to have a role that encroaches and interferes with that of legislature and the executive — par-ticularly in job creation issues that could impede the pace of achievement of fi scal policy objectives. Several reforms have been proposed (Basel Committee on Banking Super-vision, 2012) of the BIRS (Financial Executives Interna-tional, 2012). Th ey include the following:

(i). Th e Fed’s dual mandate for monetary policy should be eliminated. While it is clearly important for national economic policy to be designed to achieve ‘full employment,’ which varies over time based on domestic and global conditions, and to keep unem-ployment and underemployment as low as possible, this should not be the Federal Reserve’s job.

(ii). Th e Fed’s monetary policy should be that of promot-ing relatively stable prices and reasonable long-term interest rates. By doing so, it can help create an eco-nomic environment that will facilitate economic growth and job creation.

(iii). Instead of the Fed, the US Congress and the Presi-dent should be working together to address the many structural and sustainability challenges that directly aff ect economic growth and job creation.

Even though it is further added that while ‘the Fed needs to provide reasonable transparency regarding its decisions on monetary policy, after those decisions have been made,’ it is also mentioned that ‘it should be able to conduct its research and deliberations on monetary policy without being subject to audit, in order to facilitate sound and non-political decision-making.’ After the LIBOR and EURIBOR scandals, should the Fed be exempt from audit? Indeed, should any federal regulator or supervisor be exempt from audit?

Melvyn King, the former Governor of the Bank of England, made a signifi cant reference to the independence of the central bank in the UK. He declared: ‘How much discretion to give to the Monetary Policy Committee and how much should remain with the Chancellor is an inter-esting question that was raised, but not fully resolved, in 1997,’ referring to the date when the Bank gained opera-tional independence (Reuters, 2013).

However, despite the emphasis on central bank inde-pendence, a lack of absolute independence (from political spheres) could prove symbiotic in the sense that, despite the need for a certain degree of independence from politi-cal interference, certain events which are capable of dev-astating consequences need to be responded to as promptly as possible. Furthermore, subjecting actions and decisions of the central bank to other authorities should actually incorporate greater accountability and transparency into the supervisory and regulatory framework.

Conclusion

In the wake of the EURIBOR and LIBOR rigging scan-dals, the British Bankers’ Association (BBA) in September 2012 indicated its willingness to give up its role in setting LIBOR rates. Whether such a role should be assigned to another body does not constitute the crucial issue, since the new authority could still be controlled or infl uenced by the 18 contributing banks which submit loan data to the LIBOR board every morning, as well as help set the global rate to which their own trading bets are tied. In

6 Compare this vision with that of the intended European Monetary Union Framework outlined by Praet (2012), a member of the executive board of the ECB: ‘On the central bank side, the maintenance of price stability over the medium-term is the most important contribution that monetary policy can make to sustainable growth, employment, and social cohesion. On the fi scal side, the institutional framework refl ects our long-standing experience that sound and sustainable fi scal policies are in turn fundamental to fostering longer-term sustainable economic growth. Following these principles, monetary and fi scal policies are mutually re-enforcing. Solid fi scal policy is conducive to a macroeconomic environment that facilitates the task of a stability-oriented central bank. At the same time, credible monetary policy contributes to a smooth conduct of fi scal policies by guaranteeing stable infl ation expectations and low infl ation risk premia, which is in turn benefi cial for the level and volatility of long-term government bond yields and therewith sovereign fi nancing costs.’

LIBOR, EURIBOR, and the Regulation of Capital Markets 123

Copyright © 2014 John Wiley & Sons, Ltd. Strategic Change DOI: 10.1002/jsc

other words, the system of self-regulation that currently governs the BBA’s operations as well as EURIBOR pro-cedures urgently needs to be reviewed.

Furthermore, bank regulators and banks need to be engaged on a greater level (than at present) in the calcula-tions of LIBOR and EURIBOR rates, rather than the process of merely designating the benchmark rate deter-mination to money market traders. Such traders are con-sidered to exhibit higher tendencies for confl ict of interest.

While penalties and fi nes have been imposed on those banks involved in the recent ‘cartelization’ and rate-rig-ging scandals, the cost of rate rigging (inclusive of the costs for tax payers) is considered to be proportionately high relatively to those fi nes. Furthermore, the passiveness and indiff erence of many national regulators and supervi-sors to rate-rigging suspicions and practices constitutes a cause for concern. Greater accountability and responsibil-ity would need to embrace the involvement of national regulators and supervisors. While the free market is con-sidered by some to be capable of regulating itself and evolving with technological and global developments, some form of policing in the form of adequately balanced regulation is required to ensure that market participants do not exploit those opportunities arising from gaps in the regulatory and supervisory process.

Th e predecessors to the Basel III agreements were often criticized for their failure to address system-wide risks. It is therefore commendable that Basel III places some degree of focus on such risks. Th e use of external auditors should also serve as a means of incorporating increased checks and accountability into the regulatory process. Th e transfer of supervisory powers back to the Bank of England in July 2013 should, hopefully, signify an era which introduces (or rather reintroduces) greater implementation of external auditors’ expertise in contrast to the reduced level of use of external auditors by its pre-decessor, the Financial Services Authority.

Th e recent rate-rigging scandals serve as reminders that externalities occur within capital markets. Perfect

markets do not exist and, even though markets are con-stantly evolving, too much belief in their effi ciency could actually result in undermining and hindering the quest for optimally eff ective regulatory measures.

References

Basel Committee on Banking Supervision. 2012. Progress Report on Basel III Implementation. Bank for International Settle-ments: Basel, Switzerland.

Böll S, Martin H, Pauly C, Schulz T, Seith A. 2012. Th e cartel behind the scenes in the Libor interest rate scandal. Der Spiegel, August 1. Available at: http://www.spiegel.de/international/business/the-libor-scandal-could-cost-leading-global-banks-billions-a-847453.html.

Committee on Economic and Monetary Aff airs. 2012. Public Hearing on Tackling the Culture of Market Manipulation. European Parliament, Luxembourg.

D’Arista J. 2002. Financial regulation in a liberalized global environment. In Eatwell J, Taylor L (eds), International Capital Markets: Systems in Transition. University of Cambridge Press: Cambridge.

Finance Watch. 2012. Finance Watch response to parliament on LIBOR and EURIBOR. Available at: http://www.fi nance-watch.org/2012/09/fi nance-watch-response-to-parliament-on-libor-and-euribor/.

Financial Executives International. 2012. Th e role of the Fed Reserve. March. Available at: http://www.fi nancialexecutives.org/KenticoCMS/Financial-Executive-Magazine/2012_03/Th e-Role-of-the-Federal-Reserve.aspx#axzz2lrKNHLOK.

Grey B. 2012. Libor scandal exposes banks’ rigging of global rates. Available at: www.globalresearch.ca/libor-scandal-exposes-banks-rigging-of-global-rates/31783.

Merco Press. 2012. Euro zone to tighten fi nancial regulation following the Libor rigging scandal. Available at: en.mercopress.com/2012/07/09/euro-zone-to-tighten-fi nancial-regulation-following-the-libor-rigging-scandal.

Philipponnat, T. 2012. Remarks by the Secretary General of Finance Watch, Committee on Economic and Monetary

124 Marianne Ojo

Copyright © 2014 John Wiley & Sons, Ltd. Strategic Change DOI: 10.1002/jsc

Aff airs of the European Parliament Public Hearing on Tackling the Culture of Market Manipulation.

Praet P. 2012. Monetary policy at crisis times. Lecture held at the International Center for Monetary and Banking Studies, Geneva, February 20. Available at: http://www.ecb.int/press/key/date/2012/html/sp120220.en.html.

Reuters. 2013. Bank of England’s King says time to review infl ation targeting, January 22. Available at: http://www.reuters.com/article/2013/01/22/britain-boe-king-idUSL9E8E503Q20130122.

Treasury Today. 2012. LIBOR troubles: What should you be doing? Available at: http://treasurytoday.com/2012/07/libor-fi xing.

BIOGRAPHICAL NOTE

Marianne Ojo is a Professor with the Faculty of Commerce and Administration, School of Economic and Decision Sciences, North-West University, South Africa. She is a postdoctoral researcher at the Legal Scholarship Network, as well as a university lecturer at Covenant University and a visiting scholar at the University of Heidelberg.

Correspondence to:

Marianne Ojo

c/o Dalene Vorster

Faculty of Commerce and Administration

School of Economics and Decision Sciences

Private Bag X2046

Mmabatho 2735

South Africa

e-mail: marianneojo@hotmail.com