REFORMING THE BENCHMARKS: SIMILARITIES AND DIFFERENCES BETWEEN LIBOR AND EURIBOR

march 2013 REFORMING THE BENCHMARKS: SIMILARITIES AND DIFFERENCES BETWEEN LIBOR AND EURIBOR David Ellis, PhD Bruno Campana, CAIA

REFORMING THE BENCHMARKS: SIMILARITIES AND DIFFERENCES BETWEEN LIBOR AND EURIBOR Markets are said to be efficient if prices reflect all available information. Governments and regulators therefore introduce and develop laws, rules and procedures to try and ensure that price-sensitive information is released in a timely, fair and efficient manner. Undoubtedly, one of the most important initiatives taken by regulators has been the multiple investigations into allegations of unfair competition and manipulation of LIBOR and its Eurozone equivalent, EURIBOR, and the resulting proposals to reform these widely-used interest rate benchmarks. At the time of writing, three banks (Barclays, UBS and RBS) have announced settlements with authorities in the US, Switzerland and UK. The materials released by the regulators have provided at times graphic illustrations of concerted efforts to manipulate LIBOR rates in numerous currencies and maturities. This has led to extensive debate among various members of the financial community as to the state of interest rate benchmarking in general and whether these benchmarks in particular should be replaced or repaired. As mentioned by the International Organization of Securities Commissions (IOSCO), concerns over the fragility of such systematically important benchmarks have the potential to undermine market confidence, which may affect the real economy and investors. Whilst market authorities acknowledged that investigative initiatives were implemented a long time after the first allegations were raised to the Federal Reserve in 2008, at the time of writing important progress has been made by regulators (the European Commission 1,2, the FSA 3,4 ) and international standards setters (IOSCO 5 ) to reform the benchmarks. While most of the attention has been on LIBOR and TIBOR (the Japanese equivalent of LIBOR), another interest rate that has also been the subject of investigation is EURIBOR, a benchmark constructed by the European Banking Federation ( EBF ) that is related to interbank lending denominated in Euros. 6 Whilst market practice has been to use BBA LIBOR for USD and EBF EURIBOR for EUR as the accepted benchmarks, and whilst these benchmarks are often subject to similar allegations, both benchmarks differ by definition and construction. The London Interbank Offered Rate (LIBOR) is the primary benchmark for short term interest rates globally and is used as the basis for settlement of various financial instruments. In the mid-80 s, banks were actively trading new instruments such as Interest Rate Swaps, Foreign Currency Options and Forward Rate Agreements. LIBOR was introduced by the British Bankers Association ( BBA ) in 1986 as a measure of uniformity for these new markets. The original aim was to provide an estimate of banks funding costs in the absence of observable transactions data by asking the banks to answer the question: At what rate do you think inter-bank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am? This prior definition reflected each submitter s estimate of another prime bank. 7 1 http://europa.eu/rapid/press-release_ip-12-846_en.htm?locale=en 2 http://europa.eu/rapid/press-release_memo-12-963_en.htm?locale=en 3 PS13/6 http://www.fsa.gov.uk/static/pubs/policy/ps13-06.pdf The FSA announced it would directly regulate the new Libor administrator still to be chosen which will replace the British Bankers Association (BBA) in administering the Libor calculation. 4 martin Wheatley, chief executivedesignate of the FCA, published its review of Libor and reforming the benchmark in September 2012. 5 In 2012, IOSCO published a consultation report, Functioning and Oversight of Oil Price Reporting Agencies, which examined the role played by Oil Price Reporting Agencies (PRAs) in the functioning of oil markets. In February 2013 IOSCO published a consultation report for financial benchmarks. 6 For example, the Barclays settlement announcements include discussion of the bank s rate submissions for EURIBOR. 7 http://www.bbalibor.com/bbalibor-explained/definitions Reforming the Benchmarks: Similarities and differences between LIBOR and EURIBOR 1

In 1998, BBA changed the LIBOR definition to reflect the rate that each entity could borrow at rather than their views on the rate at which member banks could borrow from each other: The rate at which an individual contributor Panel Bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 11:00am London time. 8 The number and list of contributing banks varies by currency, but there is some overlap. For example LIBOR USD and EUR currently have 18 and 15 contributing banks respectively. LIBOR is currently published for ten currencies (USD, AUD, GBP, CAD, DKK, EUR, JPY, NZD, SEK and CHF) and 15 maturities per currency (overnight, 1 week, 2 weeks, and monthly from 1 to 12 months) totaling to 150 fixings. Some currencies and maturities will be discontinued in June this year following reforms from regulators. Data submitted by panel banks into the LIBOR process is received and processed by the designated Calculation Agent, Thomson Reuters ( TR ). TR calculates the composite benchmarks according to guidelines provided by the Foreign Exchange and Money Markets Committee ( FX&MM Committee ). 9,10 The final published rate is calculated as the interquartile mean of the quotes collected by TR. According to the guidelines, the top 25% and bottom 25% of the banks contributions are removed, and an arithmetic average is then calculated using the remaining quotes. The fixings are then published by TR after 11.00am GMT. EURIBOR uses a similar approach to LIBOR except that it was created at a later date by the European Banking Federation ( EBF ), and has been the money market reference rate for the euro since 30 December 1998. There are some significant differences, however, between these two benchmarks: there are more contributing banks (currently 42), the trimmed arithmetic average excludes the top and bottom 15% (rather than 25%), and it has a slightly different definition: EURIBOR is the rate at which euro interbank term deposits are being offered within the EMU zone by one prime bank to another at 11.00 a.m. Brussels time ( the best price between the best banks ) 11 While both the BBA and the EBF provide benchmarks in both USD and EUR, market practice has been to treat BBA LIBOR for USD and EBF EURIBOR for EUR as the accepted benchmarks. As well as being a measure of banks cost of unsecured funding, both benchmarks are referenced by and/or used to price a broad spectrum and enormous volume of exchange traded and OTC transactions, including Eurodollar futures and options, vanilla and exotic interest rate swaps, consumer loans, commercial and residential mortgages, foreign exchange derivatives, corporate loans, asset backed securities, floating rate notes, structured notes and many other instruments. In short, all instruments whose payoff or market value is linked to LIBOR or EURIBOR will have some degree of sensitivity to changes in those benchmarks. Instruments trading on other markets which may use LIBOR or EURIBOR to discount expected cash flows may also be impacted by changes in the value of these benchmarks. 8 http://www.bbalibor.com/bbalibor-explained/definitions 9 This committee is composed by a group of thirteen active market practitioners 10 LIBOR is currently quoted and published for ten currencies (USD, AUD, GBP, CAD, DKK, EUR, JPY, NZD, SEK and CHF) and 15 maturities per currency (overnight, 1 week, 2 weeks, and monthly from 1 to 12 months) making 150 fixings in total. 11 http://www.euribor-ebf.eu/assets/files/euribor_code_conduct.pdf. This is in fact similar to the original definition of LIBOR that was replaced in 1998: At what rate do you think inter-bank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am? 2 FTI CONSULTING, INC.

Data from the BIS indicates that, as of June 2012, the total notional amounts of outstanding OTC interest swaps denominated in USD and EUR were USD122 trillion and USD133 trillion respectively. The Wheatley Review of LIBOR published in September 2012 states that LIBOR is referenced by contracts worth well in excess of USD300 trillion. 12 The FSA reports that LIBOR is the most frequently used benchmark for interest rates globally and that it is referenced in OTC and exchange traded transactions with a total notional outstanding value of at least USD 500 trillion, which is equivalent to approximately seven times the global GDP. 13,14 Figure 1: EUR and USD IRSs notional amounts outstanding (all counterparties net), from end June 1998 (mm of USD) 200,000,000 180,000,000 160,000,000 140,000,000 120,000,000 100,000,000 80,000,000 60,000,000 40,000,000 20,000,000 0 1998-H1 1998-H2 US dollar Interest rate swaps All counterparties (net) 1999-H1 1999-H2 2000-H1 2000-H2 2001-H1 2001-H2 2002-H1 2002-H2 2003-H1 2003-H2 2004-H1 2004-H2 2005-H1 2005-H2 2006-H1 2006-H2 2007-H1 2007-H2 2008-H1 2008-H2 2009-H1 2009-H2 2010-H1 2010-H2 2011-H1 2011-H2 2012-H1 Euro Interest rate swaps All counterparties (net) LIBOR and EURIBOR are also the basis for exchange traded derivatives (options and futures) on the London International Financial Futures and Options Exchange ( LIFFE ) and the Chicago Mercantile Exchange ( CME ). EURIBOR is also traded via options and futures on the European Exchange ( EUREX ). As displayed in Table 1, the open interest in LIBOR and EURIBOR futures contracts (the value of outstanding contracts) are materially less important than the outstanding notional traded on the OTC market for both benchmarks. However, the outstanding agreements traded on exchanges for futures and options is still economically important and again demonstrates that both benchmarks are actively traded by market participants in Europe and in the US. Table 1: Open Interest Value (USD bn) as of 22 February 2013 CME LIFFE EUREX Total EURIBOR EUR 0.02 186.28 1.35 187.65 LIBOR USD 228 25.62 N.A. 253.69 Source: Data reported by CME, LIFFE and EUREX on Bloomberg 12 The Wheatley Review of LIBOR September 2012: http://cdn.hm-treasury.gov.uk/wheatley_review_libor_finalreport_280912.pdf 13 http://www.fsa.gov.uk/static/pubs/final/rbs.pdf 14 USD 69.97 Trillion end of 2011 according to the World Bank Reforming the Benchmarks: Similarities and differences between LIBOR and EURIBOR 3

The wider composition of the EURIBOR panel reflects the requirement imposed by the EBF that there be banks from every country in the Eurozone. This means that while the LIBOR panel is composed of many of the largest banks in the world, the EURIBOR panel comprises a much more diverse group of institutions, including many smaller ones. Table 2 below, compares the list of panel banks for EURIBOR and Euro-LIBOR (the BBA equivalent), and shows the degree of overlap between the two. Table 2: Overlap between EBF EUR and BBA EUR: EBF EURIBOR EUR 15 BBA LIBOR EUR 16 Austria Erste Group Bank AG N.A. Belgium Belfius, KBC N.A. Finland Nordea, Pohjola N.A. France Germany Banque Postale, BNP-Paribas, Société Générale, HSBC France, Natixis, Crédit Agricole s.a., Crédit Industriel et Commercial CIC Landesbank Berlin, Deutsche Bank, Commerzbank, DZ Bank, Norddeutsche Landesbank Girozentrale, Landesbank Baden-Württemberg Girozentrale, Landesbank Hessen Thüringen Girozentrale HSBC, Société Générale Deutsche Bank AG Greece National Bank of Greece N.A. Ireland AIB Group, Bank of Ireland N.A. Italy Intesa Sanpaolo, Monte dei Paschi di Siena, Unicredit, UBI Banca N.A. Luxembourg Banque et Caisse d'épargne de l'état N.A. Netherlands ING Bank Rabobank Portugal Caixa Geral De Depósitos N.A. Spain Other EU International Banco Bilbao Vizcaya Argentaria, Banco Santander Central Hispano, CECABANK, CaixaBank S.A Barclays Capital, Den Danske Bank, Svenska Handelsbanken UBS AG, J.P. Morgan Chase & Co, Bank of Tokyo Mitsubishi N.A. Abbey National plc, Lloyds Banking Group, The Royal Bank of Scotland Group, Barclays Bank plc Bank of Tokyo-Mitsubishi UFJ Ltd, UBS AG, JP Morgan Chase, Credit Suisse, Mizuho Corporate Bank, Royal Bank of Canada, Citibank NA Source: EBF and BBA As shown for the 3 Month tenor in Figure 2, BBA LIBOR EUR ( BBA EUR ) and EBF EURIBOR ( EBF EUR ) both exhibited the same shape and levels but started to spread by approximately 5bps in mid-2009. 15 http://www.euribor-ebf.eu/euribor-org/panel-banks.html 16 http://www.bbalibor.com/panels/eur 4 FTI CONSULTING, INC.

Figure 2: BBA EUR v. EBF EUR 3 Month 3 22 2.5 17 12 Rate % 2 1.5 1 0.5 7 2 0-3 -8-13 Spread (Bps) 0-18 Spread EBF EURIBOR EUR 3 Month BBA LIBOR EUR 3 Month Source: Data reported by BBA and EBF on Bloomberg This 5bps difference between the two benchmarks can be attributed to the difference in calculation (25% vs. 15% top and bottom trimmed average), the number and overlap of panel banks (15 vs. 39) as shown in Table 2, and, more importantly, the European sovereign debt crisis. As shown in Table 2, due to its composition EBF EUR is by default more representative of European Banks in general and will therefore be more sensitive to the European financial system than BBA EUR, which reflects primarily large international banks. Hence, in our view the 5bps spread on average represents the additional risk premium required by European banks for borrowing in EUR on an unsecured basis. Despite the slight change in level both rates remained highly correlated, with a correlation of 0.98 before June 2009 and 0.88 after June 2009, as shown in Figure 3. Figure 3: Correlation between BBA USD v. EBF USD 3 Month pre- and post- June 2009 4% Pre June 2009 Post June 2009 2% Change EBF EUR 3M 2% 0% -2% -4% -6% -8% 1% 0% -1% -2% -3% -4% -10% -10% -8% -6% -4% -2% 0% 2% 4% 6% -5% -4% -3% -2% -1% 0% 1% 2% Change BBA EUR 3M Source: FTI Calculations from Data reported by BBA and EBF on Bloomberg Reforming the Benchmarks: Similarities and differences between LIBOR and EURIBOR 5

The mid-2009 breakpoint follows the increased uncertainty about the strength of the European financial system, the recapitalisation of Irish Banks (Anglo Irish, Allied Irish Bank and Bank of Ireland), the frequent and large rate cuts by the ECB (75 bps in December 2008, 50 bps January 2009, 50 bps March 2009, 25 bps April 2009, 25 bps May 2009), and the beginning of the European Sovereign Crisis with the instability of the Greek economy. EBF EUR, reflecting contributions from Greek and Irish Banks (which are not included in the BBA EUR panel), was by nature more exposed to these events, hence providing a possible explanation for the widening in spread. The spread remains and has widened further recently. In 2012, French banks and their European counterparts suffered from the segmentation of markets in euros, due to their sovereign debt exposure and regulatory changes. On 26 May 2010 the EBF also launched EURIBOR USD ( EBF USD ) which has 14 contributing banks, four banks fewer than BBA LIBOR USD ( BBA USD ) which currently has 18 contributing banks. As shown in Figure 4, we observe a difference in the level of EBF USD and BBA USD. These could be due to the reasons discussed above (i.e., lack of overlap and different calculation methodologies between two benchmarks). However, contrary to our observations on the EUR benchmarks, correlation between EBF USD and BBA USD is low (less than 0.3). This is in our view partly explainable by the composition of the Panel. As shown in Table 3, there is no overlap between the panel banks contributing to each benchmark and the geographical coverage is different. Hence it is not surprising that the benchmarks show very different historical patterns of behaviour. Figure 4: BBA USD v. EBF USD 3 Month 1.2 1 0.8 Rate % 0.6 0.4 0.2 0 EBF USD EURIBOR 3 Month BBA LIBOR USD 3 Month Source: Data reported by BBA and EBF on Bloomberg 6 FTI CONSULTING, INC.

Upon examining the contributed data, BBA USD exhibits a stepwise function with flat periods over one week and sometimes more than a month, and an annualized standard deviation of 5.2%. EBF USD is three times more volatile, with an annualized standard deviation of 15.5%. This could be due to the fact that European banks holding European sovereign bonds (particularly French banks) faced massive withdrawals of deposits by non- French banks, due to the increased perceived counterparty risk inherent to the Eurozone. From June 2011 onwards French banks were faced with a dollar liquidity crisis; this can be seen in the fact that US prime money market funds exposure to European banks plunged from USD 160bn in June 2011 to USD 40bn in September 2012. These events, combined with the relatively important position of France in the Eurozone s financial system, forced French banks to reduce their dollar denominated assets compared to those of other European banks. French banks had lost up to USD 140bn in short-term funding at end-november 2011 and were able to obtain help from the ECB and other collateralized market funding sources (i.e. repo transactions). On 29 June 2011, a consortium of several of the largest central banks decided to allow the prolongation of US dollar liquidity-providing operations until 1 August 2012. 17 Between June 2011 and August 2012, the maturity of US prime money market funds obtained by French banks went form 60 days to 7 days on average. US money market funds exposure to French banks via repo increased from 30% on average in June 2011 (for BNP Paribas, Société Générale and Credit Agricole) to 80% on average in September 2011, reflecting a reluctance to lend to these banks on other than a collateralised basis. 18 Between June 2011 and August 2012 USD funding sources became scarce for European banks. It is therefore not surprising to observe flat contributions (no changes) at the 3M tenor for the BBA USD benchmark and a relatively higher average rate for the EBF benchmark. As shown in Table 3, EBF USD is more exposed to European banks; it is therefore not surprising to see a higher average cost of funding in EBF USD than in BBA USD in Figure 4. As shown in Table 3, BBA USD is more exposed to the most important French (SG, BNP, CA-CIB) and German Banks (DB) than EBF USD. As mentioned by Natixis Economic research department By tradition, French banks have a far greater presence than their European counterparts in structured financing, e.g. for the aerospace industry, for which the US dollar is the underlying currency. Their US dollar exposure is therefore greater than that of their European counterparts. It is therefore not surprising to observe a lower volatility in the BBA USD given the decreased liquidity faced by French banks. In addition to this, as we will discuss later, it is also not surprising to see French banks contributions to BBA USD be frequently above the average in that period. It is to be noted that on 13 December 2012 the ECB again extended the liquidity swap arrangements until February 2014. 19 17 These were the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of England and the Swiss National Bank. 18 Natixis Economic Research November 6, 2012 - No. 740 19 ibid Reforming the Benchmarks: Similarities and differences between LIBOR and EURIBOR 7

Table 3: Overlap between EBF USD and BBA USD: EBF EURIBOR USD BBA LIBOR USD Austria Erste Group Bank AG N.A Belgium KBC N.A France Germany Natixis/BPCE Landesbank Berlin, Norddeutsche Landesbank Girozentrale, Commerzbank AG BNP Paribas, Credit Agricole CIB, Société Générale Deutsche Bank AG Netherlands N.A Rabobank Portugal Caixa Geral de Depósitos N.A Spain Banco Bilbao Vizcaya Argentaria SA, Banco Santander, Caixa Bank SA, CECABANK N.A Turkey Turkiye Garanti Bankasi A.S. N.A Other EU International N.A Bank of China, CITIC Bank International Barclays Bank plc, Lloyds Banking Group, The Royal Bank of Scotland Group Bank of America, Bank of Tokyo-Mitsubishi UFJ Ltd, Citibank NA, Credit Suisse, JP Morgan Chase, Royal Bank of Canada, Sumitomo Mitsui Banking Corporation, HSBC, The Norinchukin Bank, UBS AG Source: EBF and BBA Additionally, the broader composition of the EURIBOR panel means that it is comprised of banks with a wider range of risk profiles than the very large banks in the LIBOR panel. This in turn implies that there is likely to be a wider distribution of panel banks cost of funds and therefore a higher estimated benchmark rate. The basic approach taken here to compare EURIBOR and LIBOR demonstrates that while both indicators are important for market stability, they represent different sets of information (different banks), and therefore may not react similarly to the same market events. LIBOR and EURIBOR differ by definition and by composition; therefore comparisons between the two benchmarks have some limits, an obvious one being that they do not address or reflect the same liquidity pools. 8 FTI CONSULTING, INC.

For further information, please contact: EDITORS: David Ellis PhD Managing Director david.ellis@fticonsulting.com Bruno Campana CAIA Director bruno.campana@fticonsulting.com Editorial Team: Vivian Lee Associate vivian.lee@fticonsulting.com Marco Shek Associate Chun Yin Shek chunyin.shek@fticonsulting.com Rachel Scarfe Research Analyst rachel.scarfe@fticonsulting.com Lun Yaoguo Research Analyst lun.yaoguo@fticonsulting.com About FTI Consulting FTI Consulting, Inc. is a global business advisory firm dedicated to helping organisations protect and enhance enterprise value in an increasingly complex legal, regulatory and economic environment. FTI Consulting professionals, who are located in all major business centres throughout the world, work closely with clients to anticipate, illuminate and overcome complex business challenges in areas such as investigations, litigation, mergers and acquisitions, regulatory issues, reputation management and restructuring. More information can be found at www.fticonsulting.co.uk. 2013 FTI Consulting, Inc. All rights reserved.