Trader For London IG Group
A trader reacts on the IG Group trading floor in London March 18. Reuters

In response to the Libor scandal that rocked the banking world last year, the world’s most powerful central bankers called for prompt action on Monday to replace the tarnished Libor interest rate benchmark with a range of reliable and robust reference rates.

Barclays PLC (NYSE:BCS), Royal Bank of Scotland Group PLC (NYSE:RBS) and UBS AG (NYSE:UBS) have all settled Libor-rigging charges in the past 12 months and agreed to pay a total of about $2.5 billion in fines. There’s still a long list of potential candidates. At least 10 regulators around the world are investigating as many as 20 of the world’s biggest financial institutions.

The London Interbank Offered Rate, or Libor, is a key short-term interest rate used in all sorts of financial transactions, from setting your adjustable-rate mortgage to interest-rate swaps bought by state and local governments.

The rate is supposed to be based on what a group of banks say is their daily cost of borrowing money from other banks for short periods of time. The problem is that these borrowing costs are self-reported and it is quite easy for the reporting banks to manipulate the rates if they want to.

Bank of England Governor Mervyn King said in a statement on Monday that the reporting regime could no longer be left solely in the hands of the private banks. "It is clear that central banks must play an important role in supporting the development of alternative reference rates," he said.

King chairs a committee of central bankers at the Bank for International Settlements, or BIS, which on Monday published a report on the role central banks could play in creating a choice of rates.

The loss of confidence in reference rates, because they had been shown to be unreliable, could lead to market functioning disruption, especially as some contracts do not have robust fallback arrangements, according to the report.

Also, poorly conceived reference rates could transfer risks, particularly those related to bank funding costs, in inappropriate ways.

Similarly, they could transfer pricing errors across financial markets or create greater and unnecessary basis risk. Unreliable reference rates may also impair the central bank’s ability to respond to financial fragilities in an effective manner, the report said.

“There is demand for a range of reference interest rates that are suitable for different purposes,” the report said.

Central banks can promote alternative rates such as overnight rates and overnight index swaps, or OIS, rates, the report said.

Overnight rates are the interest rates at which money market participants borrow and lend at overnight maturities. OIS is a particular form of interest rate swap, whereby, for the life of the contract, parties agree to swap a floating interest rate -- based on compounded overnight interest rates -- for a fixed interest rate.

And as it turns out, the Libor rate-rigging scandal isn’t unique. Interest rates all over the world are mostly made up, according to a recent study by the International Organization of Securities Commissions, or, IOSCO, a copy of which was obtained by Bloomberg News.

The study found that more than half of the benchmark lending rates in the U.S., Europe and Asia are "calculated by methodologies that were unclear, not transparent and only rarely subject to specific regulatory standards or obligations.

“The risk of manipulation will be greater where participants in the process have both incentive and opportunity to submit inaccurate data or apply a methodology inaccurately,” IOSCO wrote, according to Bloomberg. “Furthermore, where judgment is required in determining the data to be submitted, the problem is particularly acute.”

U.S. regulators’ probe into the setting of prices for gold and silver supports the study’s findings.

The Commodity Futures Trading Commission is examining the setting of prices in London, in which a handful of banks meet twice daily and set the spot price for a troy ounce of physical gold, the Wall Street Journal reported, citing people familiar with the situation.

The London gold price setting involves units of five banks: Barclays, Deutsche Bank AG (NYSE:DB), HSBC Holdings PLC (LON:HSBA), the Bank of Nova Scotia (TSE:BNS) and Societe Generale SA (EPA:GLE), according to the WSJ. The silver pricing involves Bank of Nova Scotia, Deutsche Bank and HSBC.