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.

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