Monday, July 2, 2012

Regulatory forbearance key to dragging Bank of England into Libor scandal

One of the pernicious side effects of the opacity of bank balance sheets is that it allows regulators to engage in regulatory forbearance under which banks can take actions with the regulators' blessing that would not be permitted under ordinary circumstances or if banks were required to provide ultra transparency.

Regular readers are familiar with how policymakers and financial regulators adopted the Japanese model for handling a bank solvency led financial crisis.  Under the Japanese model, policies are adopted to protect bank book capital levels.  One such policy is regulatory forbearance which allows banks to keep zombie borrowers alive by using 'extend and pretend' techniques.

Was this idea of regulatory forbearance at the heart of the misunderstanding between Barclays and the Bank of England?

Nobody is disputing that a conversation took place between a senior official at Barclays (Bob Diamond) and a senior Bank of England official (Paul Tucker).

Nobody is disputing that as a result of the conversation, Barclays subsequently manipulated Libor by submitting results that were dramatically below its true cost of funding in the interbank market.

The question is why was there a misunderstanding.

Your humble blogger would suggest that this misunderstanding was the direct result of the policy of regulatory forbearance.

Put yourself in Mr. Diamond's position, the regulators have already told you they will do what is possible to hide the losses on and off your firm's balance sheets.  This includes moving to suspend mark-to-market accounting and permitting 'extend and pretend'.

Now a central banker calls up and asks why your Libor submissions are so high they indicate the firm is under stress.

Whether intended or not, the clear message is lower your Libor submissions.

There is confirmation that this is the message when Barclays looks at what its competitors are submitting for rates.

The question becomes how to prevent misunderstandings like this from ever occurring again.  The answer is to require banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

This disclosure prevents future misunderstandings in two ways.

First, it eliminates the regulators' ability to adopt regulatory forbearance.  Everyone can see which loans or investments are in trouble and as a result discipline is exerted on the banks to recognize their losses.

Second, it eliminates the banks' ability to lie as Libor can be based on actual trades and not on fantasy.

As reported by the Telegraph,

Barclays stepped up its efforts to rig interest rates after its chief executive personally spoke to the deputy governor of the Bank of England. 
Bob Diamond had a conversation with Paul Tucker about how much Barclays was claiming it had to pay to borrow money during the financial crisis in 2008. 
After Mr Diamond spoke to Mr Tucker, Barclays staff came to believe the Bank of England wanted them to falsify this data — which was used to calculate Libor, the interest rate that banks pay to each other. 
The bank’s traders then escalated their secret attempts to manipulate the markets and make it appear that the bank was paying less to borrow money than was actually the case, documents show. 
Last night sources at both banks insisted this was the result of a “misunderstanding”. They insisted that Mr Tucker had not sanctioned Barclays’ actions. 
At the time the Bank of England was keen to see a lower Libor rate, as that would have been a positive sign in the depths of the credit crunch.

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