Friday, September 28, 2012

Wheatley Review rejects transparency in favor of complex rules and regulatory supervision

The Wheatley Review rejects transparency and recommends complex rules and regulatory supervision for reforming Libor.

Rather than focus on what the Wheatley Review recommended, I like to look at what it rejected and the explanation for the rejection.  On page 63 of the report we find,
Transaction-based rate
A.21 LIBOR is currently compiled from a daily survey of participating banks, asking for their assessment of the market for inter-bank deposits. The discussion paper also presented a discussion on whether the benchmark could be created mechanically using deposit transaction data. 
A.22 Many responses to the discussion paper noted that in an ideal scenario, that the use of transaction data would be the best solution to reforming LIBOR. However, most respondents also recognised that there would be many problems with such an approach, agreeing with our initial analysis. 
Your humble blogger read the responses that the Wheatley Review made available over the Internet.    The most frequently cited problem is a myth from the bank lobby world.  The myth is that there is a stigma attached to having the market see a bank's cost of funds on an unsecured basis.

This is simply not true.  Even the Wheatley Review talks about other related markets like overnight swaps as providing insight into a bank's cost of funds.

Publishing actual transactions as contemplated under the best solution to reforming Libor is simply not going to create a stigma.

In fact, the reverse is true.  Any bank that is unwilling to publish the data needed to support the best solution for reforming Libor is waving a huge red flag and telling the market that the bank has something to hide.

Finally, the responses from Barclays and RBS don't indicate that there would be any problems that would prevent using transaction data and having the ideal solution.
A.23 In particular, the issues associated with changing the LIBOR mechanism to a rate based on transaction-prices include: 
  The number of transactions under the current LIBOR definition of inter-bank lending is particularly thin for certain maturities and currencies.
This reflects the simple fact that the inter-bank lending market has been effectively closed since 2007.  It closed when banks with deposits to lend realized that they could not assess the risk of the banks looking to borrow because of a lack of disclosure.
  Transaction rates may reflect other elements than pure inter-bank borrowing. They may be “bids”, or rates that reflect other specific circumstances between the borrower and the lender.
By making the banks disclose all of their transactions, market participants can select which transactions they want to include in Libor.
 Difficulties with compiling a benchmark in the absence of sufficient relevant transactions. One solution could be to use the previous day’s rate. However, in periods of sustained illiquidity, the benchmark would effectively become fixed, and unreflective of the true state of wider market conditions (not just wholesale funding), which could cause market disruption.
Oliver-Wyman suggested that the solution to getting sufficient relevant transactions was to unfreeze the inter-bank lending market.

Your humble blogger proposed a simple solution for restarting the inter-bank lending market by requiring the 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 could assess the risk of the banks looking to borrow continuously.  This would unfreeze the inter-bank market and keep it unfrozen.
  A transaction data approach is not immune to manipulation. Particularly in a low volume environment, only a small number of transactions at off-market rates would be sufficient to move the final rate fixing. Manipulation of this type may be harder to monitor as it could be attempted by both internal and external parties.
Actually, a transaction data approach based on ultra transparency is effectively immune to manipulation.  Remember that sunlight is the best disinfectant.

Market participants who engage in trades based on Libor have an incentive to monitor to see if there is any hint of manipulation.  If there is, they can exert discipline on the bank or banks involved.
  There may also be operational issues arising from the timing of a fix based on trading data. Overnight cash deposit rates, such as SONIA use data collected throughout the trading day and fixed at the close of the market (approximately 5pm). By contrast, LIBOR fixes at 11am for all currencies and this timing is embedded into most contracts. Use of transaction data means that either:
  the timing of the fix would have to change;
  a partial days’ transaction data must be used; or
  or data from two calendar days must be used (24 hour period before 11am).
These are mechanical problems that are easy to work out.
Establishing a trade repository would be potentially complex and costly. 
This statement is another bank lobby myth and the fact that the members of the Wheatley Review accept it shows that they are unfit for further involvement in financial regulation.

It is common sense that the database to hold each bank's transaction data is only slightly more complicated than the database each bank runs.  Each bank knows that the transactions in its database are for itself.  The larger database is slightly more complex because it has to track transaction by bank.

Let us talk about cost.

How much is it worth to restore trust in the financial markets?

According to the Wheatley Review, over $300 trillion of securities are based on Libor.  Manipulating Libor by 1 basis point (one one-hundredth of one percent or 0.01%) is worth $30 billion annually.

No wonder an RBS trader observed "it's just amazing that fixing Libor can make you that much money".

If it is worth $30 billion annually to the banks to manipulate Libor, is it worth $30 billion annually to restore trust in Libor and the financial markets?

$30 billion is far more than it would cost to provide ultra transparency and provide the market with the best solution for reforming Libor.  I am talking here about the actual cost of running a data warehouse to collect, standardize and disseminate the data.  I am not talking about the lost income to the banks and their traders from ending the manipulation of Libor.

Instead of recommending the best solution for reforming Libor, the Wheatley Review recommends a combination of complex rules and regulatory supervision which everyone knows the banks will promptly game for their benefit (manipulating Libor is a major source of earnings and prior to Barclays regulators did nothing about it while it was going on since at least the early 1990s).

Why do I keep hearing the refrain about 'none are so blind as those whose job depends upon it'.

The first recommendation in the Wheatley Review is that regulators be given the authority to create the complex rules, supervise their implementation and punish anyone who manipulates Libor.

It is not surprising that the regulators need this authority.

Under the FDR Framework, which the UK also adopted after WWII, regulators are responsible for ensuring that market participants have access to all the useful, relevant data in an appropriate, timely manner so they can make a fully informed investment decision.

Regulators have the authority if they choose to use it to provide the market with the best solution for reforming Libor by compelling disclosure and punishing anyone for making a false disclosure.

However, the best solution for reforming Libor does not result in growing the regulatory platform.  So, no surprise, transparency is rejected in favor of reliance on complex rules and regulatory supervision.

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