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:  wheatleyreview@hmtreasury.gsi.gov.uk

The Wheatley Review

HM Treasury


1 Horse Guards Road

London

SW1A 2HQ

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.

Conclusion

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.