Monday, October 1, 2012

After a weekend to consider Wheatley's Libor recommendations, reviews point out harmful unintended consequences

After a weekend to consider Martin Wheatley's recommendations for fixing Libor, reviewers have concluded that not only will Libor not be fixed, but the result will be worse than where we currently are.

Regular readers are not surprised by this for the simple reason that the only way to fix Libor was to adopt your humble blogger's call for banks to provide ultra transparency.

It is only with banks disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details that the interbank lending market unfreezes and remains unfrozen.

It is only with this level of disclosure that market participants can see all of each bank's actual trades.  With all of the trades visible, it is possible for the market participants to analyze those trades used to calculate Libor to see if there is manipulation.

A Bloomberg article discusses the negative unintended consequences from implementing Wheatley's recommendations for fixing Libor.

Borrowing costs for consumers and companies will rise as efforts to revive confidence in Libor increase the number of banks involved in setting the rates, which determine more than $300 trillion of securities. 
A higher number of lenders will include smaller, weaker institutions that pay more to borrow, according to James Edsberg at Gulland Padfield, a London-based financial services consultancy....
“If you expand the panel by including banks beyond the largest ones, you will boost borrowing costs,” said Edsberg..... 
As part of the revamp the FSA will encourage more banks to submit quotes and will have powers to force the unwilling to take part in the process, Wheatley said in his report. The banks that will make up the pool will be selected by the new administrator, said Chris Hamilton, a spokesman for the FSA, who declined to comment further.
With the ability to force banks to submit quotes, the new administrator has the ability to redefine what Libor is suppose to represent.  Is it the rate that 'largest' banks borrow at?  Is it the rate that the 'most creditworthy' banks borrow at?

Originally, Libor reflected the rate the largest banks could borrow at regardless of their credit rating.
Rising borrowing costs risk deepening Europe’s debt crisis, making it harder for countries in the grips of austerity to foster economic growth....
A definite unintended consequence.
The panel setting Euribor includes National Bank of Greece (TELL) SA in Athens, which is awaiting recapitalization, and Bank of Ireland Plc, that country’s biggest lender. There are also four Italian lenders, including Intesa Sanpaolo SpA (ISP) and UniCredit SpA (UCG), the two largest, and four Spanish banks including Banco Bilbao Vizcaya Argentaria SA (BBVA) and Banco Santander SA (SAN), also the two biggest. 
The British Bankers Association panel for euro Libor includes Santander unit Abbey National Plc as the only lender connected to the peripheral countries. 
“On day one of the new rate being introduced it will jump higher if you increase the number of participating banks beyond the biggest ones that currently set it,” said Ian Gordon, a London-based analyst at Investec Plc. (INVP) “That obviously raises questions about the viability of the contracts that reference the old rate. It would seem to be a fundamental flaw in the new proposals.”...
Another unintended consequence.
“If you expand the panel to include a set of smaller banks, all else being equal that would tend to push up the average rate,” said Steve Hussey, a London-based financial- institutions analyst at AllianceBernstein Ltd., which oversees about $400 billion. “You could weight it by size or rating but that would be complex and may not be effective.”
As I previously pointed out, the Wheatley recommendations substitute complex rules and regulatory supervision for simple transparency.
Wheatley proposes allowing banks to wait three months before disclosing their Libor submissions, rather than publish them daily as at present. While immediate publication of individual submissions increases transparency, it makes manipulation easier because contributors are able to estimate the impact of the quote they put in.
Not if the banks are required to provide ultra transparency and disclose all their trades.  With this data, it is obvious who is submitting quotes that are not reflective of their borrowing experience.
Added to that, at times of stress, changes in submissions may be viewed as reflecting the contributor’s credit strength, offering an incentive to submit a lower rate than otherwise, according to the report. 
To rectify the “reduction in immediate transparency” the report recommends lenders publish a regular bulletin that includes trading volumes. 
“A three-month wait and then we find out that some of these institutions are more wobbly that we thought,” said James Ferguson, chief strategist at Westhouse Securities Ltd. in London. “That’s a horrible legacy for us to leave for the next crisis.”
Mr. Ferguson's observation summarizes why ultra transparency is needed to fix Libor and the Wheatley recommendations should be tossed in the recycle bin.

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