Libor ignored the crisis in Cyprus that's roiling financialmarkets, showing the global benchmark for $300 trillion ofsecurities remains divorced from reality six months afterregulators laid out a plan to fix it.

Just four of the 18 banks contributing to the London interbankoffered rate in U.S. dollars increased submissions last week toshow a rise in their estimated borrowing cost, as concern grewabout bank runs and bailouts in Europe. UBS AG and BNP Paribas SAwere among those reporting no change.

That week, the average cost to insure banks against defaultsoared 12 percent, credit-default swaps show. The amount lenderspaid to borrow cash from each other overnight, as measured by theovernight-indexed swap rate, rose more than 8 percent.

“Instead of providing the most accurate quote of their interbankborrowing costs, banks are playing safe and trying to provide theleast-risky quote given current investigations,” said RosaAbrantes-Metz, an economist with New York-based consulting firmGlobal Economics Group Inc.

Libor is calculated daily through a survey in London that asksbanks how much it costs them to borrow cash from each other forvarious durations in different currencies. Banks including UBS andRoyal Bank of Scotland Group Plc were given record fines over thepast year for making false submissions to that survey.

With little interbank trading as banks tap other fundingsources, lenders are forced to guess what their borrowing costsmight be, leaving the rate open to inaccuracy and abuse.

Three-month dollar Libor rose 0.5 basis points, or 0.005percentage point, to 0.285 percent between March 15 and March 22 asEuropean policy makers clashed over a rescue for Cyprus and theisland's lawmakers resisted a plan to impose a tax on bankdeposits. That increase shows banks estimate it costs less than 2percent more to borrow than a week earlier.

During the same period, the average cost of a five-year contractto insure the senior debt of banks on the dollar Libor panelagainst default jumped by 11.9 percent as credit-default swapwriters demanded a higher premium. Concern that a Cyprus deposittax may prompt savers to pull funds from weaker banks elsewhere inthe euro region helped send European stocks sliding.

Since March 22 the divergence between Libor and CDS hascontinued to grow. By March 27, three-month dollar Libor haddropped back 0.1 basis point to 0.284 percent, while the averagecost of a CDS contract on the banks had risen a further 15.3percent. It's now 28 percent more expensive to insure the banksagainst default than it was on March 15, compared to the 1.4percent increase to the Libor rate.

New Regulator

Britain is adopting a plan that aims to improve the way theLondon interbank offered rate is set. The Libor scandal eruptedafter London-based Barclays Plc was found to have made artificiallylow submissions during the financial crisis to avoid the perceptionthat it was under stress.

“Libor may not be being manipulated currently, but it is notresponding to market conditions the way it would be expected,” saidAbrantes-Metz, who is also an associate professor at New YorkUniversity's Stern School of Business. “That compromises thereliability of Libor as a key benchmark, to the detriment of themarket.”

The U.K. Financial Services Authority approved reforms this weekthat will see the Prudential Regulatory Authority, the newfinancial regulator, given responsibility for overseeing therate-setting process, including corroborating submissions andmonitoring suspicious conduct.

Libor rate-setters, who usually work in a bank's treasurydepartment, are no longer allowed to consider the views ofderivatives traders who stand to benefit from where the rate isfixed each day. Traders found guilty of attempting to rig the ratecan be jailed.

Martin Wheatley, head of the PRA, said on March 25 that the newrules would “restore faith” and “bring integrity back to Libor.”Chris Hamilton, a spokesman for the U.K. regulator, declined tocomment.

The U.K. reforms “are designed to make sure Libor keepsfunctioning because it is the benchmark for so many contracts,”Abrantes-Metz said. “That is necessary, but users should startlooking to alternatives.”

'Fragile System'

Australia this week scrapped the panel that sets its benchmarkinterbank rate, becoming the first major developed economy toreplace its rate-setting regime following the rigging scandal. Thenation's bank-bill swap rate will be compiled directly using pricesfrom brokers and electronic markets instead of asking a panel ofbanks, according to the Australian Financial MarketsAssociation.

Though the heightened regulatory scrutiny makes it harder fortraders to manipulate Libor for their own gain, Gary Gensler,chairman of the U.S. Commodity Futures Trading Commission, has saidthe rate remains flawed given Libor still relies on estimates of amarket with very few transactions.

“Propping up a fragile system in the interest of maintaining asense of stability only creates more instability in the end,”Gensler said in a Feb. 28 speech in New York. 'One can buy anartificial sense of calm for a while, but when that calm cracks,the resulting turmoil is invariably greater.”

Before the financial crisis, Libor and credit-default swapstended to move in tandem. As perceptions of bank risk grew, CDScontracts became more expensive and lenders in money marketsdemanded higher interest rates for short-term financing. Thatrelationship has broken down as Libor has become less responsive tomarket events, Abrantes-Metz said.

Last week, the divergence between CDS and Libor was particularlypronounced among the European lenders on the Libor panel. Of the 11European banks that provide rates, eight left their submissionsunchanged.

They included French bank BNP Paribas, whose CDS jumped 18percent over the period; Swiss lender UBS, whose CDS rose 15.9percent; and Edinburgh-based RBS, whose CDS rose 9.6 percent.Spokesmen for the three banks declined to comment.

The U.S. dollar overnight-indexed swap rate, which gives anindicator of how much banks are paying to borrow cash from eachother overnight and is based on actual trading, jumped to 0.1475percent from 0.1362 over the same period, an 8 percentincrease.

That meant the spread between Libor and the overnight indexedswap rate, a closely-followed barometer of stress in the market,fell to its lowest level in 19 months on March 22, the last day ofa week where Cyprus's crisis pushed Treasuries and gold higher ondemand for the safest assets.

“This kind of divergence is going to keep happening,” saidAndrew Verstein, a lecturer at Yale Law School in New Haven,Connecticut, and co-author of a paper on Libor rigging published inthe Winter 2013 issue of the Yale Journal on Regulation. “You maysee peculiar results, but as long as there is good governance andevery effort to stop abuse, the market may decide that it wants tokeep using Libor.”

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