Wednesday, July 18, 2012

BoE's Mervyn King calls for 'radical reform of the Libor system'

As reported by the Wall Street Journal, the Bank of England's Mervyn King has written a letter to the world's leading central banks asking them to dinner to discuss 'radical reform of the Libor system'.

Regular readers know that your humble blogger has already suggested how to reform the Libor system in a simple way that is consistent with the intent of what the Libor interest rate is suppose to show and that market participants can have confidence in.

Specifically, I have recommended that banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The reason for doing this is so that Libor could be based off of all the actual trades.

One of Mr. King's main concerns in the letter is what happens if there are no trades for a particular Libor currency or maturity.

There are two reasons that there might not be trades.  First, the interbank lending market is frozen.  Second, banks elect not to trade in that currency or maturity.

The interbank lending market has frozen repeatedly since the beginning of the financial crisis because banks cannot assess the risk of any other bank.  As a result, the banks cannot determine the proper amount or price for their exposure to any other bank and therefore, the banks do not lend.

The reason for requiring banks to provide ultra transparency and disclose all of their exposures and not just their funding exposures is that ultra transparency provides the data that each bank needs in order to assess the solvency of every other bank and determine the amount and price they are willing to lend to each of the other banks.

Ultra transparency is the key to unfreezing the interbank lending market and to preventing it from freezing again.

So long as the interbank lending market is functioning, there are a number of ways to determine a Libor interest rate when a specific currency or maturity is not traded.  For example, if there are trades available to calculate a Libor interest rate for both a shorter and longer maturity than the maturity that was not traded, it is easy to mathematically determine an interest rate for the non-traded maturity.

Your humble blogger is agnostic to which of these solutions is adopted.  What is important is that there is ultra transparency so that the interbank lending markets do not freeze in the future.

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