Next on the financial front: a new and improved Libor

I apologize to my regular readers for the limited number of posts recently, but I have been working on my response to the Wheatley Review on how to improve Libor.

As discussed in the Wall Street Journal, rolling out a new and improved mechanism for setting Libor is on the regulatory fast track.

My response focuses on how to credibly fix Libor and restore market confidence.  So naturally, it is based on requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This disclosure cures multiple problems.

First, it unfreezes and keeps unfrozen the interbank lending market.

This market is currently frozen as a result of banks being 'black boxes'.  As a result of the lack of adequate disclosure, banks with money to lend cannot assess the risk of banks looking to borrow.  Fortunately, the banks with money to lend have an alternative as they can invest their money in government securities rather than blindly betting on the borrowing banks.

By requiring the banks to provide ultra transparency, banks with money to lend can access all the useful, relevant information in an appropriate, timely manner to independently assess the risk of a borrowing bank.  With this assessment, the lending bank can adjust both the amount and price of their exposures to the borrowing banks.  The result is that the interest rate on interbank loans truly reflects the  true cost to the bank of borrowing unsecured debt.

Since the disclosure is ongoing, the interbank market remains liquid (although the borrowing banks might not like the cost of funds that their risk suggests they should pay).

Second, it allows Libor to be based off of actual trades rather than off of easily manipulated guesses.

We've had the Summer of Love, the Winter of Discontent and the Arab Spring. Now get ready for the Autumn of Libor.... 

But for traders, regulators and investors, the return from vacation will be dominated by talk of Libor—the flawed interest rate that governs at least $300 trillion of financial instruments. And not just because several banks will follow Barclays PLC and pay regulators to settle charges that they tried to manipulate Libor. 

After convincingly impersonating the Keystone Kops for years, U.K. regulators have sprung into action with plans to reform Libor, raising the prospect of a complete overhaul in coming months.... 

As the man in charge of the reforms, Martin Wheatley, a top official at the U.K.'s Financial Services Authority, told me last week: "This is bigger than just Libor. It's about investor confidence in financial markets so we want to fix it."...

As regular readers know, the only way to restore investor confidence in the financial markets is to provide ultra transparency.  Confidence flows because investors trust their own independent analysis of all the useful, relevant information.

His recipe for fixing Libor can be read between the lines of a paper he issued a couple of weeks ago. Ostensibly, the 58-page report keeps an open mind. But because the U.K. government is rushing to enshrine the Libor changes into legislation—responses are due in by Sept. 7 and Mr. Wheatley has to make his recommendations by the end of that month—the broad outlines are taking shape. Indeed, Mr. Wheatley will be stateside this week for discussions with U.S. regulators. 

In short, Libor is likely to remain the key financial rate but with important modifications to the way it is calculated and policed. 

Talk of replacing Libor with other benchmarks is likely to remain just that for two reasons: No substitute would easily work for all the financial instruments Libor serves, and rewriting derivatives contracts tied to Libor would be an herculean, and legally fraught, task. 

The "new and improved" Libor would almost certainly do away with the current gymnastics-scoring-meets-clairvoyance method of calculation. 

At present, large banks submit daily estimates of their costs of funding to a trade group, which eliminates the highest and the lowest numbers and calculates the rate as the arithmetic mean of the rest. Banks aren't required to say whether those estimates reflect their true cost of funding—an omission that increases the scope for manipulation. 

A simple-sounding remedy would be to force banks to use actual market transactions. The problem is that it would be hard to find enough deals covering all of Libor's 15 maturities and 10 currencies, especially in periods of financial stress.

Actually, this lack of deals is a reflection of the interbank lending market being frozen.  It is easy to permanently thaw this market:  require the banks to provide ultra transparency.

The most likely solution is a hybrid system in which banks would still quote their estimated costs but would be required to back them up with as many actual transactions as possible and document how they got to the numbers. 

"Blending quote- and transaction-based approaches may prove to be the most practical solution," Anthony Murphy, a former HSBC PLC executive who is now at the consultancy Promontory Financial Group LLC, wrote in a recent note.

A hybrid system is something championed by the banking industry seeking to retain opacity.

Mr. Wheatley said there is support for a hybrid approach. "People are saying, 'You just can't leave it to pure judgment; you have to have the real input.'"...  

Better calculations and stricter policing should make Libor more credible. Whether they will buttress the investing public's confidence in the process, however, is another matter.

Regular readers know that anything short of ultra transparency is inadequate for restoring confidence.