Sunday, September 30, 2012

The myth of fixing Libor

In his NY Times column, Floyd Norris looks at Libor and asks if the recommendations put forth by Mr. Wheatley will actually fix it.  His conclusion:  no.

He is not alone in this conclusion.  For example: the Bank of England's Mervyn King said more has to be done so that Libor is reliable in a future crisis; and the Bloomberg editors said that the recommendations stopped short of providing market participants with the transaction level data that is needed to restore trust.

The reality of Mr. Wheatley's recommendations is that they substitute complex rules and regulatory oversight for transparency.

While this is a solution that the Blob (aka, financial regulators, bankers and their lobbyists) would like, it is a solution that market participants distrust.

Everyone knows that the only way to 'fix' Libor is by requiring the banks to provide ultra transparency and disclose all of their current global asset, liability and off-balance sheet exposure details.

This disclosure allows banks with deposits to lend to independently assess the risk of the banks looking to borrow.  This unfreezes and keeps unfrozen the interbank lending market.

This disclosure provides all the data needed for calculating Libor and, equally importantly, for market participants to independently check to see if banks are trying to manipulate the rate.

Mr. Wheatley did not make this recommendation.

In fact, by not publishing my firm's response to the Wheatley Review initial discussion paper, he avoids have to deal with the simple fact that ultra transparency solves the problems with Libor far more effectively and than complex rules and regulatory supervision.
Sometimes modern finance has a great need for something, and so bankers invent products that appear to fill that need. When it turns out that the invention was actually something else entirely, people are shocked....

So it is now with Libor — the London interbank offered rate — ... That there was fraud based on made-up numbers is clear. That the system can be fixed is not. 
But Martin Wheatley, Britain’s top financial regulator, has concluded Libor can be saved. “Although the current system is broken, it is not beyond repair,” he said in remarks prepared for delivery on Friday. 
He may turn out to be overly optimistic. Libor is, and is likely to remain, a fiction. You can maintain the fiction, or you can embrace a much less palatable reality....
Libor rates are calculated each day by the British Bankers’ Association, a trade group that makes good money from licensing the use of Libor rates. Each day panels of banks tell the association the rate they will have to pay for unsecured loans at maturities ranging from overnight to 12 months. They do that for each of 10 currencies, including the United States dollar, the euro, the Swedish krona and the New Zealand dollar. 
The scandal made clear that those reports were faked before and during the financial crisis by at least some of the banks. 
But what is not as widely appreciated is that there is substantial evidence that the deception goes on. Banks continue to report figures that strain credulity, both in their level and in their lack of volatility from day to day or week to week.  
The scandal might never have surfaced, or might have done so in a sanitized fashion, had bank regulators had their way. But the banks had the bad fortune that the investigation of it was spearheaded by the United States Commodity Futures Trading Commission, a market regulator that ... had no institutional need to protect the banks, and it did not.
This week Mr. Gensler, testifying before a European Parliament committee, laid out the evidence that the deception continues, although he was nice enough not to put it in such stark terms. He noted the wide swings in the cost of credit-default swaps on debts issued by major banks, while those same banks were reporting that their costs of unsecured borrowing were varying hardly at all. 
“It is critical that markets be able to rely on something that is credible and honest. The data in the market now strains that credibility,” Mr. Gensler said in an interview before Mr. Wheatley’s conclusions were announced. “History shows that something that is prone to abuse will be abused, and that even people of good faith can have a difficult time estimating when there are no observable transactions.”...
These days neither number [including Libor and Euribor] is based on real transactions, since there is virtually no interbank unsecured lending. ...
Mr. Gensler says that a replacement for Libor should be based on observable market transactions, not subject to manipulation.
The position of your humble blogger.
Mr. Wheatley evidently entered into his research having decided that Libor must be saved. 
Proving that Libor is “beyond repair” would not be enough, he said. There would also have to be “a better alternative” that already existed, and a way to make “an immediate and smooth transition.” It was obvious that the last two criteria could not be met. 
His solution is to put a new group in charge of Libor and to slim it down by purging small currencies and most maturities. “This will reduce the current number of Libor reference rates — 150 — down to 20 where we are confident there is a real market to underpin the rates,” he said.
 It will be interesting to see his evidence that such a market exists. He evidently knows there is not much of one. 
We don't have a real market because there is virtually no interbank lending market.  Even the firm that compiled the statistics showing the market is closed suggests that the focus should be on reopening the market.
He would still allow banks to submit rates not based on transactions, but would make them disclose that fact. There would be new regulations aimed at forcing banks to be honest. 
His conclusions seem to be based on the same kind of logic that got us into the mess in the first place. Without a benchmark, floating rate loans are impossible. We need floating rate loans. Therefore, there must be a good benchmark.... 
Libor was manipulated by bankers long before the financial crisis, and it is still based on calculations that have little basis in reality. 
Mr. Wheatley assures us that more regulation can deal with conflicts of interest. There will, he promises, be a “clear code of conduct” and “clear rules,” enforced by a regulator with “extensive powers.” 
Pollyanna lives.
Regular readers know that the only way to restore trust is through transparency.

More regulation (clear code of conduct and clear rules) and regulatory oversight (extensive powers) is a substitute for transparency and market discipline that favors the Blob to the detriment of other market participants.

Ed Milibrand shows how the Blob huffs and puffs and does nothing to reform banks

As reported by the Guardian, UK Labour leader Ed Milibrand says he would push through the modern day equivalent of Glass-Steagall and separate the 'casino' operations from the retail operations.

"Either they can do it themselves – which frankly is not what has happened over the past year – or the next Labour government will, by law, break up retail and investment banks. 
"The banks and the government can change direction and say they are going to implement the spirit and principle of Vickers to the full. That means the hard ringfence between retail and investment banking. We need real separation, real culture change. Or we will legislate."
Mr. Milibrand said he was sincere about pursuing this policy.

Critics of such a policy argue it would lead the banks to abandon the UK as their base. 
The Labour leader told BBC1's Andrew Marr show he did not believe that would happen but said that, if it did, he was ready to face them down. 
"I think what the British people want is a prime minister that will do the right thing for the country," he said. "Do you want somebody who will stand up to the powerful vested interests in our country or not? 
This whole position would be great except for one small problem:  ring-fencing is a solution endorsed by the Blob (aka, financial regulators, bankers and their lobbyists).

No less an authority than Paul Volcker has already said that it will not work in a time of financial crisis.

Regular readers know that ring-fencing is simply another way of substituting complex regulations and regulatory oversight for transparency and market discipline.

Without requiring both 'casino' and retail banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, how can any market participant independently assess how much risk is being taken?

Ring-fencing doesn't help in the assessment of risk and ultimately, as Mr. Volcker observed, breaks down at a time of crisis.

The one area where ring-fencing is helpful is drawing attention away from the fact that ultra transparency is needed to truly reform banks.

RBS Stephen Hester: Bank reform will take a generation

As reported by the Telegraph, RBS chief Stephen Hester thinks that bank reform will take a generation.
Mr. Hester was specifically referencing the "culture" of banking in an interview in the bank's corporate magazine.

Regular readers know that the culture of banking could be easily changed overnight by requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed so the bright light of sunshine can act as the best disinfectant to cleanse the banking system of the bad behavior exhibited in manipulating Libor, mis-selling interest rate swaps or gambling with taxpayer money.

It is amazing how fast the banking culture would change if everything bankers did today was known before the opening of business tomorrow.

Mr. Hester's observation is just another effort by the Blob (aka, financial regulators, bankers and their lobbyists) to use a myth to frame discussion of bank reform.

Saturday, September 29, 2012

Robert Peston: fixing global finance requires reigning it in

In his Guardian column, Robert Peston concludes that fixing the mess we are in requires reigning in global capital.

Regular readers know that the way to reign in global capital is to bring transparency to all of the opaque corners of the financial system.  Transparency subjects global capital to the best disinfectant: sunlight.

With sunlight, each participant in the global financial system encounters a force greater than it is:  the market.  Specifically, each participant is subject to market discipline.

Subjecting global capital to transparency harnesses market discipline to clean up and fix this mess.

"How do we fix this mess?" That may be one of the stupidest questions I have ever asked myself, as of course I don't know the answer. What I do know, however, is that few of the structural flaws in how the global economy operates, which took us from unsustainable boom to intractable bust, have been fixed.... 
Here are just a few of the surreal characteristics of the worldwide financial and economic system that is our lot. 
We have global regulations for banks that incentivise them to make it impossible for ordinary mortals – including their owners, regulators and even their own directors – to know with confidence the risks they are running.
This reflects the fact that current disclosure practices leave banks resembling 'black boxes'.

This can be fixed by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this data, market participants can independently assess the risks the banks are running.
And at the same time these rules encourage senior bank executives to run their respective operations in a way that maximises the short-term profits they make – and of course their pay and bonuses – subject to those regulations, rather than simply concentrating on providing the credit and services of most use to their customers. 
I am referring to the so-called Basel rules, set by a largely unaccountable priesthood of regulators and central bankers who meet in camera in a sleepy Swiss town and have determined how banks protect themselves against shocks since the 1980s. Think of these money priests as the financial equivalents of the members of Fifa's governing body or the International Olympic Committee – which is not to suggest that there has ever been a hint of corruption at the Basel committee on banking supervision, but is to say that transparency and openness are not the strongest suits of a committee whose recommendations have a powerful bearing on all our livelihoods. 
The Basel rules were originally designed to ensure that all big banks anywhere in the world retained a minimum amount of capital relative to their loans and investments, to absorb losses when it all goes wrong. In other words, they were supposed to make the banking system safer and to create a level playing field between banks. 
In practice, and almost from the start, the rules were written in such a complicated way that they created a virtual licence for clever bankers and their respective banks to cheat. And the devastating consequence is that they actually allowed banks to become both dangerously enormous and to hold less capital relative to their loans than at any point in history, although you could not see how weak banks had become because of the eccentric way that the rules calculate capital and risk.
The rules were introduced to let banks increase their leverage in an opaque way so that they could generate a higher ROE and presumably be better able to attract capital from the markets.
Which brings me to an elephant that has been in the room in which prime ministers and business leaders swank and swagger for 20 years – namely that globalisation is real and (ahem) global, but government is national. 
Or to put it another way, the flaws in globalisation cannot and will not be tackled effectively unless and until there are much better mechanisms for politicians and people to hold in check global capital and global businesses.

Bloomberg editors: Wheatley Review reform of Libor stopped short

In a column, the editors of Bloomberg effectively endorsed your humble bloggers call for banks to provide ultra transparency as the measure that would have actually reformed and restored trust in Libor.

The U.K. finally has a plan to overhaul the London interbank offered rate, the deeply flawed benchmark that has, for more than two decades, set the payments made worldwide on mortgages, corporate loans and derivatives.... 
Martin Wheatley, the U.K.’s chief financial regulator, faced a quandary in early July when he started a review of Libor amid overwhelming evidence of manipulation. He had to tread carefully, lest changes render null and void the more than $300 trillion in contracts tied to the benchmark. At the same time, he had to do something to restore trust in one of the world’s most important financial indicators. 
Created in the 1980s, the Libor system could hardly have been better designed for corruption.  
The calculation of the benchmark, which is supposed to provide an objective picture of interest rates across 10 currencies and 15 time periods, relies on self-reported estimates from banks that have huge incentives to game the system. 
The same banks control the British Bankers’ Association, the trade group that owns and purports to police Libor. 
The entire process exists completely outside the purview of regulators [or market participants]. Not surprisingly, misbehavior ensued....
Misbehavior that was well hidden behind a veil of opacity.
Wheatley’s reforms, all of which we have advocated, go about as far as they can without changing the definition of Libor. The highlights: 
1) The BBA will be removed from the picture, and U.K. authorities will hold an open competition to find a new administrator. (Disclosure: ... Bloomberg has proposed its own alternative to Libor.)
In an earlier post, your humble blogger discussed how the Bloomberg proposal uses complexity to try to get around the simple fact that the interbank lending market is frozen.

Regular readers know that the simple solution for unfreezing the interbank lending market and keeping it unfrozen is to require banks to provide ultra transparency and 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 banks looking to borrow.
2) Bankers involved in setting Libor will be subjected to regulatory oversight, and manipulation will become a criminal offense.
Regulatory oversight is nice in theory.

In practice, regulatory oversight fails (see: causes of current Great Recessions).
3) The number of Libor maturities and currencies will be pared down to those in which borrowing actually occurs, a move intended to take some of the guesswork out of banks’ interest- rate estimates.
No need to pare down the number of Libor maturities if the interbank lending market is reopened.
Unfortunately, Wheatley stopped short of one measure that would have greatly improved transparency: requiring banks to report actual borrowing transactions, against which the public could check the veracity of the estimates that banks submit. 
Instead, he has recommended that even the publication of individual banks’ estimates be put on a three-month delay -- as opposed to being posted immediately. The change is intended to mitigate the stigma banks might suffer if they report rising borrowing costs during times of crisis. 
As a result, it will actually become more difficult for outsiders to assess Libor’s reliability in real time. If banks are reporting honestly, it’s hard to understand why they would object to the publication of the relevant information from actual transactions....
The idea of 'stigma' is a myth created by the Blob (aka, financial regulators, banks and their lobbyists).

In theory, banks were 'honestly' reporting their borrowing costs since the inception of Libor and 'stigma' wasn't a problem when Libor was conceived or through 2+ decades of operation.
Ultimately, the market will be better off moving away from Libor and other survey-based benchmarks to ones that rely on observable transactions.

Repost: The Future of Finance: The end of opacity and the Mother of all financial databases

This post originally appeared on November 22, 2010.  Bloomberg's Jonathan Weil linked to it (see: markets) in his column on Sheila Bair's new book when he concluded
So let’s eliminate the secrecy. It damages our economy, undermines investor confidence and gives financial institutions too much leeway to go astray. 
Regulators haven’t shown themselves to be any better than the markets are when it comes to uncovering big problems at federally insured banks. We might as well make all their examination findings open records. That way, the public can see when the regulators are failing at their jobs. Depositors can make fully informed choices about where to keep their money. And banks will be under much greater pressure to fix their problems.
The post

The future of finance is the elimination of opacity throughout the financial system by using 21st century information technology.

This statement is the logical conclusion of the Bank of England's plan to substitute market discipline for bank examination.

As discussed in an earlier post, Bank of England Adopting 21st Century Oversight of Financial Institutions,  the current model of bank examination does not work.

The current bank examination model, as practiced by regulators like the Financial Services Authority and Federal Reserve, involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide.  A key feature of this model is that no detailed information is shared with the markets.

If this model looks like it parallels how the rating agencies operate, it does.

The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator.  A CAMELS rating is for regulators eyes only and is a reflection of a bank's overall condition in the areas of capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L) and sensitivity to market risk (S).

Just like the ratings produced by the rating agencies, since the markets do not have the information to do their own homework, the markets have to trust that the regulators get their ratings right.

Unfortunately, recent history shows that regulators were just like the rating agencies and they did not always get their ratings right.

According to a WSJ article,
a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data."
Mr. Haldane identified the flaw in the bank examination model and the reason that regulators need to have banks disclose more information to the markets.

The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

Andrew Redleaf, a hedge fund manager, takes the idea of banks disclosing data and market participants using this data further.  

He wrote
the late crisis happened not because banks were reckless or regulators incompetent, though both were surely true. It happened because together banks and regulators forged a system that denied citizens and markets the information they needed to respond rationally to events.

Banking has always been too secretive in this country. Banks are quasi-public institutions, performing both private and public functions, including sustaining the credit system that sustains the dollar itself. In return, the big banks especially are granted extraordinary privileges, such as the right to borrow from the Fed virtually for free at times of crisis.
Under the circumstances there is no excuse for bank balance sheets to be anything but utterly transparent to the citizens and investors.... 
Imagine for a moment that in 2004 the government had required every major financial institution in the U.S., any one with the potential for imperiling credit markets, to publish their investment positions. All of them. In detail. Lists of every security or derivative held in their portfolios, along with all data about the underlying mortgage pools, defaults so far, etc.
With such a rule in place, the mortgage crisis likely would never have happened on the scale it did. Most of the worst mortgages, the loans that crashed the system, were written from 2005 through the early days of 2007. Opening the banks' books would have revealed just how near the edge they were playing. 
The resulting market pressure on bank securities would have forced them to cut back their mortgage books. This would have been a crisis of a sort; the housing bubble would have popped. But popping the bubble two years earlier would have avoided the worst of the damage.
Even if transparency failed to avoid the mortgage crisis, it almost certainly would have prevented the banking crisis and the crash of 2008. Because we would have known. 
We would have known how much -- or how little -- trouble Bear was in long before March 2008. We would have known, for better or worse, about Lehman, and Morgan, and Goldman, and Citi. Not instantly. 
It would take time to digest millions of lines of information kept secret for decades. But surely millions of investors poring over the information, including those heroic rag-pickers, of capitalism the vultures and short-sellers would have given us a quicker and better answer than the grand-high-poo-bahs.
The megabanks would hate it....They would scream bloody murder about being forced to let competitors see what they owned. Nonsense. 
Investors who hold interesting or unusual positions in their portfolios may have something to lose by disclosure. But too-big-to-fail banks have no business taking "interesting" positions. Banks are not supposed to be extra clever, they are supposed to be extra careful."
On February 23, 2009, in a Wired article, Daniel Roth provided the support for Mr. Haldane's observation and solution in much more detail.  
"Even the regulators can't keep up. A Senate study in 2002 found that the SEC had managed to fully review just 16 percent of the nearly 15,000 annual reports that companies submitted in the previous fiscal year; the recently disgraced Enron hadn't been reviewed in a decade. 
We shouldn't be surprised. While the SEC is staffed by a relatively small group of poorly compensated financial cops, Wall Street bankers get paid millions to create new and ever more complicated investment products. By the time regulators get a handle on one investment class, a slew of new ones have been created. 
'This is a cycle that goes on and on—and will continue to get repeated,' says Peter Wysocki, a professor at the MIT Sloan School of Management. 'You can't just make new regulations about the next innovation in financial misreporting.' 

That's why it's not enough to simply give the SEC—or any of its sister regulators—more authority; we need to rethink our entire philosophy of regulation.
Instead of assigning oversight responsibility to a finite group of bureaucrats, we should enable every investor to act as a citizen-regulator. We should tap into the massive parallel processing power of people around the world by giving everyone the tools to track, analyze, and publicize financial machinations. 
The result would be a wave of decentralized innovation that can keep pace with Wall Street and allow the market to regulate itself—naturally punishing companies and investments that don't measure up—more efficiently than the regulators ever could.

Tracking Wall Street's complex inventions may be difficult for regulators, but it's a snap given the right software....
When data is kept under lock and key, as mysterious as a temple secret, only the priests can read and interpret it. But place it in the public domain and suddenly it takes on new life. People start playing with the information, reaching strange new conclusions or raising questions that no one else would think to ask. It is impossible to predict who will become obsessed with the data or why—but someone will. 
'People care about money,' Tim Bray, director of Web technologies at Sun Microsystems says. 'There's money in money and substantial personal upside to someone who can mine the data and uncover the truth.'"
How can the disclosure pushed by regulators like Haldane and investors like Redleaf actually be implemented?

By creating the "mother of all financial databases."  This is the database that your humble blogger has been pushing since before the credit crisis (herehere and here) and is necessary if European investors are going to be able to comply with the 'know what you own" provision of Article 122a of the European Capital Requirements Directive.  

This is the database that the Office of Financial Research and Data (OFR) is suppose to develop, but because it is a governmental entity never will.  OFR is fundamentally handicapped because:
  1. The current operating philosophy of the regulators is not to share detailed information with the market.  
  2. By law it must, where possible, use information collected by other governmental agencies.  What if the frequency that another governmental agencies collects data, say monthly, is not what is required to, as Lloyd Blankfein advised, monitor every position every day?
What is required is an independent third party to run the mother of all financial databases.  The independent third party must only be in the business of managing this database.  This assures all market participants that the database is free of all conflicts of interest and they can trust the numbers.

Friday, September 28, 2012

BoE's Mervyn King: More work needed to ensure Libor reliable in future crisis

As reported by the Telegraph, the Bank of England's Mervyn King sees the recommendations for reforming Libor contained in the Wheatley Review as inadequate because they do not ensure Libor will be reliable in a future crisis.

Regular readers know that the proposed reform of Libor is inadequate because it does not base Libor off of actual transactions that are disclosed as each bank reports on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

Without the information contained in this disclosure, banks with deposits to lend cannot assess the risk of banks looking to borrow.

As shown at the beginning of the current financial crisis, when banks with deposits to lend cannot assess the risk of banks looking to borrow, the inter-bank lending market freezes.

Since banks are currently providing disclosure that leaves them resembling 'black boxes', the inter-bank lending market has remained frozen.

Unfreezing the inter-bank lending market and keeping it unfrozen requires banks to provide these exposure details.

By definition, any reform of Libor that does not require banks to provide these exposure details does not ensure Libor will be reliable in a future crisis and is simply not worth spending time discussing.

Sir Mervyn King, the Governor of the Bank of England, said he welcomed the recommendations, but added that more work would be needed to ensure that in a future crisis Libor remained a reliable reference rate. 
“Further thinking will be needed to meet the challenge of benchmarks based on thinly traded markets, especially when they are quote-based,” said Sir Mervyn. 
Under Mr Wheatley’s proposals, Libor submitters will have to keep a record of recent trades to prove the rates they enter accurately reflect their actual cost of funding. 
However, he admitted that in a crisis when funding becomes more difficult, the rates submitted by banks could still rely more on “some degree of judgment” than real trades.

In our current crisis, this "some degree of judgment" leaves Libor open to ongoing manipulation.

Wheatley Review rejects transparency in favor of complex rules and regulatory supervision

The Wheatley Review rejects transparency and recommends complex rules and regulatory supervision for reforming Libor.

Rather than focus on what the Wheatley Review recommended, I like to look at what it rejected and the explanation for the rejection.  On page 63 of the report we find,
Transaction-based rate
A.21 LIBOR is currently compiled from a daily survey of participating banks, asking for their assessment of the market for inter-bank deposits. The discussion paper also presented a discussion on whether the benchmark could be created mechanically using deposit transaction data. 
A.22 Many responses to the discussion paper noted that in an ideal scenario, that the use of transaction data would be the best solution to reforming LIBOR. However, most respondents also recognised that there would be many problems with such an approach, agreeing with our initial analysis. 
Your humble blogger read the responses that the Wheatley Review made available over the Internet.    The most frequently cited problem is a myth from the bank lobby world.  The myth is that there is a stigma attached to having the market see a bank's cost of funds on an unsecured basis.

This is simply not true.  Even the Wheatley Review talks about other related markets like overnight swaps as providing insight into a bank's cost of funds.

Publishing actual transactions as contemplated under the best solution to reforming Libor is simply not going to create a stigma.

In fact, the reverse is true.  Any bank that is unwilling to publish the data needed to support the best solution for reforming Libor is waving a huge red flag and telling the market that the bank has something to hide.

Finally, the responses from Barclays and RBS don't indicate that there would be any problems that would prevent using transaction data and having the ideal solution.
A.23 In particular, the issues associated with changing the LIBOR mechanism to a rate based on transaction-prices include: 
  The number of transactions under the current LIBOR definition of inter-bank lending is particularly thin for certain maturities and currencies.
This reflects the simple fact that the inter-bank lending market has been effectively closed since 2007.  It closed when banks with deposits to lend realized that they could not assess the risk of the banks looking to borrow because of a lack of disclosure.
  Transaction rates may reflect other elements than pure inter-bank borrowing. They may be “bids”, or rates that reflect other specific circumstances between the borrower and the lender.
By making the banks disclose all of their transactions, market participants can select which transactions they want to include in Libor.
 Difficulties with compiling a benchmark in the absence of sufficient relevant transactions. One solution could be to use the previous day’s rate. However, in periods of sustained illiquidity, the benchmark would effectively become fixed, and unreflective of the true state of wider market conditions (not just wholesale funding), which could cause market disruption.
Oliver-Wyman suggested that the solution to getting sufficient relevant transactions was to unfreeze the inter-bank lending market.

Your humble blogger proposed a simple solution for restarting the inter-bank lending market by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, banks with deposits to lend could assess the risk of the banks looking to borrow continuously.  This would unfreeze the inter-bank market and keep it unfrozen.
  A transaction data approach is not immune to manipulation. Particularly in a low volume environment, only a small number of transactions at off-market rates would be sufficient to move the final rate fixing. Manipulation of this type may be harder to monitor as it could be attempted by both internal and external parties.
Actually, a transaction data approach based on ultra transparency is effectively immune to manipulation.  Remember that sunlight is the best disinfectant.

Market participants who engage in trades based on Libor have an incentive to monitor to see if there is any hint of manipulation.  If there is, they can exert discipline on the bank or banks involved.
  There may also be operational issues arising from the timing of a fix based on trading data. Overnight cash deposit rates, such as SONIA use data collected throughout the trading day and fixed at the close of the market (approximately 5pm). By contrast, LIBOR fixes at 11am for all currencies and this timing is embedded into most contracts. Use of transaction data means that either:
  the timing of the fix would have to change;
  a partial days’ transaction data must be used; or
  or data from two calendar days must be used (24 hour period before 11am).
These are mechanical problems that are easy to work out.
Establishing a trade repository would be potentially complex and costly. 
This statement is another bank lobby myth and the fact that the members of the Wheatley Review accept it shows that they are unfit for further involvement in financial regulation.

It is common sense that the database to hold each bank's transaction data is only slightly more complicated than the database each bank runs.  Each bank knows that the transactions in its database are for itself.  The larger database is slightly more complex because it has to track transaction by bank.

Let us talk about cost.

How much is it worth to restore trust in the financial markets?

According to the Wheatley Review, over $300 trillion of securities are based on Libor.  Manipulating Libor by 1 basis point (one one-hundredth of one percent or 0.01%) is worth $30 billion annually.

No wonder an RBS trader observed "it's just amazing that fixing Libor can make you that much money".

If it is worth $30 billion annually to the banks to manipulate Libor, is it worth $30 billion annually to restore trust in Libor and the financial markets?

$30 billion is far more than it would cost to provide ultra transparency and provide the market with the best solution for reforming Libor.  I am talking here about the actual cost of running a data warehouse to collect, standardize and disseminate the data.  I am not talking about the lost income to the banks and their traders from ending the manipulation of Libor.

Instead of recommending the best solution for reforming Libor, the Wheatley Review recommends a combination of complex rules and regulatory supervision which everyone knows the banks will promptly game for their benefit (manipulating Libor is a major source of earnings and prior to Barclays regulators did nothing about it while it was going on since at least the early 1990s).

Why do I keep hearing the refrain about 'none are so blind as those whose job depends upon it'.

The first recommendation in the Wheatley Review is that regulators be given the authority to create the complex rules, supervise their implementation and punish anyone who manipulates Libor.

It is not surprising that the regulators need this authority.

Under the FDR Framework, which the UK also adopted after WWII, regulators are responsible for ensuring that market participants have access to all the useful, relevant data in an appropriate, timely manner so they can make a fully informed investment decision.

Regulators have the authority if they choose to use it to provide the market with the best solution for reforming Libor by compelling disclosure and punishing anyone for making a false disclosure.

However, the best solution for reforming Libor does not result in growing the regulatory platform.  So, no surprise, transparency is rejected in favor of reliance on complex rules and regulatory supervision.

Following in Ireland's footsteps, Spain announces bank capital shortfall that reflects politics and not reality

As reported by Bloomberg, the Spanish banking system has a 59.3 billion euro capital shortfall.  A number that is entirely consistent with the 100 billion euro bailout Spain is seeking and entirely inconsistent with actual economic reality.

Regular readers are familiar with governments destroying their credibility by engaging in rounds of hiring third parties to estimate the losses and capital shortfall in the banking system.

The reason there are several rounds is that the markets don't find the estimates credible and, more importantly wonder, what are they hiding because they are not requiring the banks to disclose all of their exposure details.

This is at least Round 2 for Spain.  Would you find an estimate of a 59.3 billion euro capital shortfall credible when the Street is talking at least 150 billion euros?

Round 3 for Spain is already in the works.  This round will be a loan by loan review (BlackRock Solutions makes a lot of money for this analysis).  This round will come much closer to 150 billion euros.

But again the question will be what are the banks hiding?

The only way to restore trust in the banking system and the size of the capital shortfall is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can calculate the losses at each bank.

More importantly, market participants can see which banks are capable of rebuilding book capital levels through retained earnings and which banks cannot.

Spain’s banks have a combined capital shortfall of 59.3 billion euros ($76.3 billion), according to a stress test designed to remove doubts about a financial industry pummeled by real estate losses. 
The Bankia (BKIA) group, a nationalized lender, had a 24.7 billion-euro capital deficit in the tests conducted by management consultants Oliver Wyman that also showed Banco Popular Espanol SA (POP) had a 3.22 billion-euro shortfall. The stress tests of 14 lenders showed no capital deficit for seven banks, including Banco Santander (SAN) SA, Banco Bilbao Vizcaya Argentaria SA (BBVA) and Banco Sabadell SA. 
Spain commissioned the independent stress test as part of the conditions agreed in July for a European bailout of as much as 100 billion euros for its banking system, which has been saddled with more than 180 billion euros of losses linked to souring real estate assets. 
The attempt to show how its banks would bear an extreme scenario in which the economy would shrink for three years in a row is part of the government’s drive to show it is fixing Spain’s economy as it considers whether to seek a further rescue package from Europe. 
“These are important stepping stones on the way for Spain,” said Holger Schmieding, chief economist at Berenberg Bank in London, referring to the stress test. Even so, “there will always be people in the market who question the numbers,” he said.
So long as bank balance sheets are 'black boxes', it is reasonable to question the numbers.  Experience has shown that those who have said the situation is worse than the latest government estimates have always been proven right.

From the Telegraph live:
Greek bad loans have hit a record of 57 billion euros, 25% of all loans.
Greek bank recap needs 50 billion euros.  Spanish 59.3 billion euros. 
Spain's figures are simply not credible despite what the official sector says (they said the same thing about Ireland too).

17.04 In a statement, the Bank of Spain said:QuoteThe 14 main Spanish banking groups (taking into account the integration processes currently under way) have participated in this test. The groups account for around 90% of the Spanish banking system’s assets.The results confirm that the Spanish banking sector is mostly solvent and viable, even in an extremely adverse and highly unlikely macroeconomic setting:• Seven banking groups, accounting for more than 62% of the analysed portion of the Spanish banking system’s credit portfolio, do not have additional capital needs.• Additional capital needs have been identified for the remaining groups, on top of those existing as at 31 December 2011, that amount to €59.3 billion when the integration processes under way and deferred tax assets are not taken into account. This amount falls to €53.75 billion when the mergers under way and the tax effects are considered.

17.10 Here is a breakdown of the banks' individual needs. The table shows that Santander is the strongest of the Spanish lenders. The lender exceeds the minimum capital requirements by at least €19bn. It's no surprise to see that Bankia is the weakest. The bank was nationalised in May.
In short: seven banks need cash. Seven don't.
The baseline scenario presumes a capital ratio requirement of 9pc for banks and a cumulative decline in real GDP of -1.7pc over the period to 2014, while the adverse scenario sees a capital ratio requirement of 6pc, which envisages a cumulative decline in GDP of -6.5% over the same period (Source: Bank of Spain/Oliver Wyman).

17.25 The European Commission has welcomed the results of the audit. In a statement, it said:QuoteThe capital needs for individual banks disclosed today are a key step in the process of restoring and strengthening the soundness of the Spanish banks. They will form the basis for the eventual recapitalisation of banks with the help of the programme. The necessary State aid provided to Spanish banks will be determined in the coming months. It will be based on today's published results. It will also reflect measures to be taken by the banks, such as the disposal of assets, other restructuring measures and tapping funding markets, and subordinated liability exercises. In addition, the capital shortfall of credit institutions receiving public funds will be adjusted as a consequence of the transfer of assets to the Asset Management Company.Banks with a capital shortfall will present recapitalisation plans. Upon approval of these recapitalisation plans by the Bank of Spain and the European Commission, banks requiring state aid will present restructuring or orderly resolution plans to the Spanish authorities, which will notify these to the European Commission for approval under EU state aid rules. Upon approval of these restructuring and/or orderly resolution plans, the recapitalisation of a first group of banks is scheduled to occur by November.

17.31 The European Banking Authority (EBA) has also welcomed the results. It said:QuoteThe assessment process and the stress test results disclosed today are a major step towards strengthening and restoring the soundness of the Spanish banking system, which is ultimately crucial for a sustained recovery of economic growth and employment.

17.39 While Jean-Claude Juncker, head of the EuroGroup, is "comforted" by the announcement. He issued this statement:QuoteThe final State aid provided to Spanish banks will be lower than the reported capital shortfall, given measures to be taken by the banks in accordance to their recapitalisation and restructuring plans.The assessment shows that the total financial assistance agreed in July should be more than adequate to cover the final capital needs, including a comfortable safety margin. It should ensure that the recapitalisation process of banks can proceed efficiently and in accordance with previously agreed timelines. I very much welcome that progress on implementing the commitments as defined in the Memorandum of Understanding is well on track. I am confident that the reforms attached to this financial agreement will contribute to ensuring a return of all parts of the Spanish banking sector to soundness and stability.
17.50 Christine Lagarde, managing director of the IMF, praised the audit's "thorough and transparent independent valuation of assets". 
It was a very thorough and transparent independent valuation of assets except of course that the banks did not provide exposure level detail so that the market participants could independently confirm the findings.

The response the Wheatley Review of Libor refused to print!

With its announcement for how to 'fix' Libor, the Wheatley Review also published responses to its discussion paper.

Conspicuous by its absence, was my firm's response.

Since the Wheatley Review refused to publish the response submitted on August 28, 2012, I thought I should.

First, the cover letter:

Dear Mr. Wheatley,

I have attached my comments to your initial discussion paper on LIBOR.  The comments focus on the simple solution for fixing LIBOR and restoring market confidence.  This solution is to require the banks to provide what I call ultra transparency.

In the 1930s, ultra transparency was routinely provided by banks as they published all their accounts fit to print.  It was the standard for a bank looking to demonstrate that it could stand on its own two feet.

Since the advent of deposit insurance, ultra transparency has been the level of disclosure provided to bank regulators.  It is seen as necessary in order to protect the taxpayer guarantee.

However, banks abandoned the practice of publishing all their accounts fit to print because they had the regulators already looking at their accounts.  As a result, market participants no longer had the information they need to independently assess the risk of the banks.

The inter-bank lending market froze in 2007 when banks with funds to lend realized that they could not independently assess the risk of the banks looking to borrow.  As a result, they stopped lending.  It has remained frozen since, with a few exceptions like when the governments guaranteed inter-bank loans.  

The way to unfreeze the inter-bank lending market is to require the banks to provide ultra transparency and disclose on an ongoing basis all the accounts fit to print.  In addition to unfreezing the inter-bank lending market, this disclosure will also provide the actual trade data that can be used as the basis for calculating LIBOR.

I look forward to talking with you and answering any questions you might have.

Second, the response:

August 27, 2012

Sent via e-mail:

The Wheatley Review
HM Treasury

1 Horse Guards Road

The Wheatley Review of Libor

Dear Mr. Wheatley:

TYI, LLC appreciates the opportunity to submit this letter in response to your request for comments on how to reform LIBOR in a way that restores market confidence.

This letter will focus on two consultation questions:  can LIBOR be strengthened in such a way that it will remain a credible benchmark and are there credible alternative benchmarks that could replace LIBOR in the financial markets.


Banks should be required to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

These details would be collected, standardized and disseminated for free to all market participants by a conflict of interest free data warehouse.

With this disclosure, the inter-bank lending market would resume functioning as banks with deposits to lend could assess the risk of banks looking to borrow.  With this assessment, banks with deposits to lend could determine who much they are willing to lend on an unsecured basis at different interest rates to the borrowing banks. 

As a result, the inter-bank lending market would unfreeze and remain unfrozen.  There would be no need for an alternative benchmark and LIBOR could be based on all or a subset of the actual trades.

Frozen inter-bank lending market drives search for alternative benchmarks

As the initial discussion paper pointed out, “LIBOR is intended to be a representation of unsecured inter-bank term borrowing costs.”   This definition assumes that there is a functioning inter-bank lending market.

However, since the beginning of the financial crisis, the inter-bank lending market has been frozen.

To get around the frozen inter-bank lending market, in his Wall Street Journal column, Daniel Doctoroff, CEO and president of Bloomberg, LP offered a complicated one-off solution.

One potential solution to this problem is to combine two types of inputs to compensate for the diminished volume in loans available for bank reference.

The first input would follow the current Libor approach. The interbank borrowing rate—the numbers they submit—will be transparent. That is, if bank X says it borrowed at rate Y, that submission to Bloomberg would be public. 

The second, supplemental inputs would consist of market-based quotes for credit default swap transactions, corporate bonds, commercial paper and other sources of credit information. Analysis of these sources of information would yield an "indicative" Blibor index.

Another way to get around the frozen inter-bank lending market would be to adopt an alternative benchmark as the basis for the LIBOR interest rate.

As describe in a Bloomberg editorial, the two leading contenders are overnight index swaps and the general collateral repo index.  Both of these contenders are flawed.

Overnight index swaps are contracts based on the so-called federal funds effective rate, which is the interest U.S. banks charge one another on overnight loans. The underlying loans are observable: The Fed records them and publishes a weighted average interest rate every day.

Problem is, banks tend to pull out of the market during times of stress, leaving it too small and too easily skewed to provide a true picture of borrowing costs.... 

In short, overnight index swaps suffer from the same problems as the inter-bank lending market.

The general collateral repo index looks like a better option. It tracks the very large market for repurchase agreements, known as repos, typically overnight loans made against good collateral such as U.S. Treasuries.

The Depository Trust & Clearing Corp. publishes a daily weighted average of the actual interest rates paid on these loans. Aside from being secured by collateral, a large portion of the loans are processed through a central counterparty that protects the system against default by any one participant. These features make the repo market, and especially the part that uses Treasuries as collateral, relatively resilient in times of crisis.

However, this index also has problems.  For starters, it does not represent the interest rate that banks can borrow on an unsecured basis.

Keep in mind that most banks these days tend to package their loans into securities. They then pledge the bundled loans as collateral when they borrow in the repo market.

The index also has similar problems to the freezing of the inter-bank lending market.  At the beginning of the financial crisis, it was exactly these loan-backed securities that could not be used in the repo market as no one could value the securities.

The initial discussion paper offers several other potential benchmarks and why their flaws make them inappropriate for use as a replacement benchmark for LIBOR. 

For example, treasury bills and the central bank policy rate have nothing to do with the rate on unsecured bank lending and rather are rates that are highly manipulated by monetary policymakers.

Bottom line:  the search for an alternative benchmark to base LIBOR off of reveals that the best solution is to unfreeze and keep unfrozen the inter-bank lending market.

Unfreezing the inter-bank lending market

Why go for the complex or substitute a flawed alternative benchmark for LIBOR when there is a simple solution for unfreezing the inter-bank lending market?

The inter-bank lending market has frozen repeatedly since the beginning of the financial crisis because lending banks do not have the information they need to assess the risk of the borrowing bank.  

Banks are, in the words of the Bank of England’s Andrew Haldane, ‘black boxes’.

But don’t take Mr. Haldane’s or my word that banks do not disclose enough information so that they can be independently assessed.  The US Financial Crisis Inquiry Commission (FCIC) reached the same conclusion.  The FCIC observed that the inter-bank lending market froze because banks could not tell which banks were solvent and which were not.

The result of the lack of disclosure is that banks with deposits to lend do not lend to banks looking to borrow because they cannot independently assess the risk of the borrowing banks and determine the proper amount or price for their unsecured exposure.

The reason for requiring banks to provide ultra transparency and disclose all of their exposure details and not just their funding details is that ultra transparency provides the data that each bank needs in order to independently assess the risk of every other bank and determine the amount and price they are willing to lend to each of the other banks.

This point needs to be repeated:  it is only with ultra transparency that banks have all the useful, relevant information in an appropriate, timely manner to independently assess the risk of lending to the other banks and that market confidence is restored.

With ultra transparency, banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, banks with funds to lend can independently assess the risk of the banks looking to borrow.  With this information, transactions that are priced to reflect the true risk of each bank can take place.

As a result, Libor can be based on what it truly costs banks to borrow on an unsecured basis.  This is what Libor was intended to represent under the definition provided in the initial discussion paper.

Basing LIBOR off of actual trades requires that the inter-bank lending market be unfrozen and can be credibly kept unfrozen in the future.  Ultra transparency is the key to unfreezing the inter-bank lending market and to preventing it from freezing again.

Basing LIBOR off of actual trades

Once the inter-bank lending market is functioning again, then the liability data provided under ultra transparency can be used in the calculation of LIBOR. 

Specifically, market participants will have access to all the inter-bank trades and can use all or a subset of these trades as the basis for determining the LIBOR interest rates.

In your initial discussion paper, you presented an analysis by Oliver Wyman of 2011 inter-bank trading data.  Since the beginning of the financial crisis in 2007, the inter-bank lending market has been essentially frozen.  The 2011 data confirms this by highlighting the lack of trades.

At a minimum, this analysis shows why ultra transparency is needed to restore a functioning inter-bank lending market. 

Without ultra transparency and a functioning inter-bank lending market, the analysis shows that the LIBOR interest rate across a range of currencies and maturities would be based off of a limited number of transactions in small, illiquid, easily manipulated markets.

With ultra transparency and a functioning inter-bank lending market, there are a number of ways to determine a Libor interest rate across all the currencies and maturities that take advantage of the most liquid inter-bank lending markets.  

For example, if there are trades available to calculate a Libor interest rate for both a shorter and longer maturity than the illiquid maturity, it is easy to mathematically determine an interest rate for the illiquid maturity.

For purpose of restoring credibility to LIBOR, regulators should be agnostic to which of these solutions is adopted.  What is important is that regulators focus on ensuring that there is ultra transparency so that the inter-bank lending markets function and do not freeze in the future.

Cost of data warehouse to support ultra transparency

One of the issues with basing LIBOR off of actual transactions and requiring ultra transparency from the banks is the issue of cost and complexity of the supporting data warehouse and information infrastructure.

My firm has done a considerable amount of work in this area and the bottom line is that neither cost nor complexity is a barrier to requiring ultra transparency and basing LIBOR off of actual trades.

Let me deal with cost first.  Specifically, there is the issue of who pays for the data warehouse and the information infrastructure. 

The banks should pay.  The banks are major beneficiaries from providing ultra transparency and basing LIBOR off of actual trades. 

Banks benefit from providing ultra transparency because market participants can independently assess their risk and are therefore willing to lend them money on an unsecured basis.

Without ultra transparency, the inter-bank lending market is effectively closed.  This implies an infinite cost of funds.

I realize that banks are currently relying on inexpensive funding from the central banks, but eventually central banks will enforce Walter Bagehot’s advice of lending at high rates against good collateral.  At this point, banks are going to realize the ‘savings’ from providing ultra transparency and having access to the inter-bank market.

Now let me turn to the issue of complexity. 

My firm patented an information infrastructure that uses a data warehouse to provide observable event based reporting on a borrower privacy protected basis for the collateral supporting structured finance securities to all market participants.  It would be simple to modify this infrastructure to support ultra transparency and basing LIBOR off of actual transactions.

Based on my firm’s expertise, setting up and operating the data warehouse and information infrastructure to support ultra transparency and LIBOR can be easily done.

I look forward to talking with you about how this can be accomplished and restoring market confidence in LIBOR.