The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.
Friday, September 28, 2012
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:
1 Horse Guards
The Wheatley Review of Libor
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
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.
would be collected, standardized and disseminated for free to all market
participants by a conflict of interest free data warehouse.
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
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.
since the beginning of the financial crisis, the inter-bank lending market has
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.
potential solution to this problem is to combine two types of inputs to
compensate for the diminished volume in loans available for bank reference.
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.
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.
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.
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.
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
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
overnight index swaps suffer from the same problems as the inter-bank lending
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.
Depository Trust & Clearing Corp. publishes a daily weighted
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.
this index also has problems. For
starters, it does not represent the interest rate that banks can borrow on an
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
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.
initial discussion paper offers several other potential benchmarks and why
their flaws make them inappropriate for use as a replacement benchmark 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.
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
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?
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.
are, in the words of the Bank of England’s Andrew Haldane, ‘black boxes’.
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.
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
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.
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.
ultra transparency, banks disclose on an ongoing basis their current global
asset, liability and off-balance sheet exposure details.
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.
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.
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
the inter-bank lending market is functioning again, then the liability data
provided under ultra transparency can be used in the calculation of LIBOR.
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
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.
a minimum, this analysis shows why ultra transparency is needed to restore a
functioning inter-bank lending market.
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.
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.
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.
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
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
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.