Wednesday, July 4, 2012

How do you solve a problem like Libor?

In his Wall Street Journal Heard on the Street column, Richard Barley asks how do you solve a problem like Libor.

Libor and its European cousin Euribor are to some extent artificial constructs, particularly following the financial crisis. 
Nearly four years ago, Bank of England governor Mervyn King said Libor was "the rate at which banks do not lend to each other."
This comment is particularly damaging to the testimony that the BoE's Paul Tucker is going to provide on his conversation with Barclays' Bob Diamond.  If the BoE didn't think the rate at which banks lend to each other, then why would Tucker have cared about Barclays' high Libor submissions?
Libor's overseer, the Foreign Exchange and Money Markets Committee and the British Bankers' Association, announced an overhaul of Libor in November 2008 after questions were raised about its accuracy. Tellingly, they left unchanged the way in which it is determined. 
A tribute to the Opacity Protection Team.
The Libor survey asks banks at what rate they could borrow unsecured funds were they to do so; the European Banking Authority's Euribor survey asks at what rate banks believe prime banks are lending to each other. Both are, therefore, perceived rates, not tied to actual deals.
Wouldn't the best answer to the Libor survey be the rate a bank actually borrowed at? Wouldn't the best answer to the Euribor survey be the rate they were lending at?

The 2008 Libor review concluded that individual deal rates couldn't be used due to confidentiality rules. 
Notice the handiwork of the Opacity Protection Team as it uses confidentiality rules as the reason for not using actual trades.

Confidentiality rules do not prevent the construction of a Libor data warehouse.  The data warehouse could collect all the trades while retaining the confidentiality of the borrower or the lender.  Stripped of these identifiers, the data on actual trades could then be used to calculate Libor.
The huge deterioration in banks' credit-worthiness since then complicates the situation. 
Unsecured bank lending before the crisis was seen as low-risk, and credit risk was homogenous. Now, banks have disparate credit ratings and risks. Much lending is now on a secured basis and funneled via central banks. 
It can be difficult to determine accurately the market price of lending. 
In many parts of the debt market, apart from ultraliquid products like Treasurys, pricing often is indicative. 
Libor generates 150 rates daily, covering 10 currencies and 15 maturities. In any one day, the likelihood that banks will have traded all of these to generate a rate submission is low.
Again, the lack of trading by any one bank is not an impediment to basing Libor off of what actually happens.  Libor currently excludes bank submissions, so not including a bank is nothing new.

The Libor data warehouse is a nice, simple solution that is highly credible as the trades can be confirmed by auditors.

If the banks were required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants could confirm the Libor interest rate for themselves.

No comments: