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.