BoE's King: "Libor system has ceased to work"

Reuters reports that according to the Bank of England's Mervyn King the 'Libor system has ceased to work' since the beginning of the financial crisis and needs to be replaced with a rate that does not reflect individual bank credit risk.

This would seem to defeat the whole idea behind using Libor as a benchmark.

Libor is suppose to reflect the banks' cost to fund themselves on an unsecured basis.  As a result, a loan based on Libor could be thought of as equal to the banks' cost to fund themselves plus a credit spread to reflect the risk of the borrower.

If Libor no longer reflects the banks' cost to fund themselves on an unsecured basis, why exactly would anyone consider it useful?

Once again, the regulators are setting off to protect the profitability of the banks and maximize the damage done to the financial system.

Regular readers know there is a simple solution to fixing Libor:  require the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information:

• Banks with deposits to lend can assess the risk of the banks looking to borrow.  This unfreezes and keeps unfrozen the interbank lending market.

• Market participants can base Libor off of actual transactions.

• There is no need for regulatory involvement in Libor or any successor interest rate.

As reported by Reuters,

The Libor system as a measure of interbank lending costs has ceased to work since the financial crisis and a fix needs to be found to support existing contracts based on the rate, Bank of England governor Mervyn King said on Wednesday. 

Britain has set out to reform the key interest rate that was rigged by a number of banks, including Barclays (BARC.L: Quote, Profile, Research), in a transatlantic scandal that is threatening to seriously damage London's reputation as a financial centre. 

The scandal has sparked a blame game among market watchdogs in the United States and Britain who are now calling for direct regulation of the benchmark, which is currently compiled and overseen by the banking industry. 

With ultra transparency, there is no need for direct regulation of the benchmark.

A single interbank borrowing rate had ceased to exist since the financial crisis as banks were now assessed according to their individual credit risks, King said during a news conference presenting the central bank's latest forecasts. 

"So the idea of having a panel to sort out what is the interbank lending rate no longer makes any sense," he said.

Why exactly does a panel make no sense when Libor is suppose to reflect an average cost of funding for banks?

In theory, banks were always suppose to be assessed according to their individual credit risk.  That is how the financial markets are suppose to work.  Why is that a bad thing now?

The simple fact is that the interbank lending market froze due to a lack of transparency.  Market participants could not then and still cannot now assess the risk of the banks.  As the Financial Crisis Inquiry Commission confirmed, banks could not tell which banks were solvent and which banks were insolvent.

Thawing the interbank lending market and fixing Libor are related.  Both require that the banks provide ultra transparency.

A British government review launched last week is looking at the potential for alternative rate-setting processes and how to move to a new regime, which may take some time as many long-term contracts are pegged to Libor, the London interbank offered rate.