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.