CFTC's Gary Gensler endorses basing Libor on actual transactions

In his NY Times' editorial, Gary Gensler, chairman of the Commodities Futures Trading Commission, called for basing Libor on actual transactions.

AMERICANS who save for the future, use credit cards or borrow money for tuition, cars and homes deserve assurance that the interest rates on their savings and loans are set in a reliable and honest way. 

That’s why the revelation that the British bank Barclays attempted to manipulate the London interbank offered rate, or Libor — one of the benchmark rates used to determine the cost of borrowing around the world — is so disturbing. 

But the Barclays case isn’t only about misconduct by large financial institutions. It also raises questions about the reliability and accuracy of these key interest rates, which are largely determined by the private sector, without significant government oversight....

Regular readers know that if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, Libor could be calculated off of actual transactions.

There would be no need for significant government oversight.

Libor is supposed to be the average rate at which the largest banks honestly believe they can borrow from one another unsecured (that is, without posting collateral).

With banks providing ultra transparency, there is no reason to abandon the idea that Libor is the average rate the banks can borrow from one another on an unsecured basis.

Actual trades can be used.

Libor was set up in the 1980s when banks regularly made loans to other banks on that basis. 

However, the number of banks willing to lend to one another on such terms has been sharply reduced because of economic turmoil, including the 2008 global financial crisis, the European debt crisis that began in 2010, and the downgrading of large banks’ credit ratings this year.

As confirmed by the Financial Crisis Inquiry Commission, the interbank lending market froze because banks with deposits to lend could not tell which borrowing banks were solvent and which were not.

With ultra transparency, lending banks can independently assess the solvency and risk of the borrowing banks.  As a result, the interbank lending market unfreezes.

The interbank lending market remains open with ultra transparency as lending banks always have access to the latest information on the borrowing banks.

Without ultra transparency,

Banks have shifted toward secured borrowing and, on occasion, borrowing from central banks like the Federal Reserve and the European Central Bank. As Mervyn King, the governor of the Bank of England, said of Libor in 2008: “It is, in many ways, the rate at which banks do not lend to each other.”...

What does Mr. Gensler think can be done to fix Libor?

When the Commodity Futures Trading Commission, which oversees derivatives markets, began looking into interest-rate setting in 2008, we were guided not only by questions about the decline of actual unsecured lending among banks, the supposed basis of Libor, but also by our founding statute, the Commodity Exchange Act. The law prohibits attempts to manipulate and falsely report information that tends to affect the price of a commodity — including interest rates like Libor. 

Markets work best when benchmark rates are based on observable transactions. The public is shortchanged if Libor, the emperor of rates, is not clothed in such transactions....

It’s time for a new or revised benchmark — an emperor clothed in actual, observable market transactions — to restore the confidence of Americans that the rates at which they borrow and lend money are set honestly and transparently.

In short, a call for banks to provide ultra transparency.