UK regulator warns banks not to leave Libor panel

The Wall Street Journal reports that the UK's Financial Service Authority as part of overhauling Libor in the wake of the manipulation scandal is telling banks not to leave the Libor interest rate setting panel.

As a practical matter, the fact that a regulator has to twist arms to keep banks on the interest rate setting panel is a clear signal that how benchmark interest rates like Libor, Euribor and Tibor are calculated is fundamentally flawed.

Regular readers know that your humble blogger suggested and the Wheatley Review refused to publish that Libor be based on actual transactions that were disclosed as part of each bank disclosing its current global asset, liability and off-balance sheet exposure details.

With this information, banks with deposits to lend can assess the risk and solvency of banks looking to borrow.  The result is that the unsecured inter-bank lending market unfreezes and remains unfrozen.

With this information and a flow of transactions in the unsecured inter-bank lending market, there is no need to worry about banks being on a panel.  Market participants can chose to base Libor off of all the transactions disclosed by the banks or a subset.

Several banks planned to withdraw from the panel that sets a key benchmark interest rate but scrapped the idea after the U.K.'s financial regulator strongly warned them against doing so, according to people familiar with the matter. 

The Financial Services Authority recently sent letters to a handful of major banks—including France's BNP Paribas and the Netherlands' Rabobank Group—warning them not to pull out of the panel that sets the London interbank offered rate, or Libor, these people said. 

The letters came after executives at those banks privately informed the British Bankers' Association, the trade organization that oversees Libor, that they planned to exit the rate-setting panel. 

The letters show the British regulator going to unusual lengths to try to salvage Libor.

The reputation of the ubiquitous benchmark, which underpins interest rates on trillions of dollars of financial products world-wide, has been marred by banks' efforts to manipulate it. Regulators and policy makers worry that if a parade of banks leaves the panels that set Libor, it will further damage the benchmark's credibility. 

Actually, everyone assumes that these benchmark interest rates are being manipulated today.  As a result, banks leaving the panel has no impact on the benchmark interest rates' credibility.

But banks are increasingly wary of being involved in setting Libor and other benchmarks, which generally are based on estimates of how much it would cost one bank to borrow from its peers. 

A dearth of lending between banks in the current tumultuous environment makes it difficult for banks to come up with accurate estimates of their borrowing costs, industry executives say. 

The dearth of lending is the direct result of the fact that banks are, in the words of the Bank of England's Andrew Haldane, "black boxes".  Banks with deposits to lend cannot assess the risk and solvency of the banks looking to borrow and therefore are unwilling to lend.

And the scandal surrounding banks' attempted rate manipulation means some lenders perceive their continued participation in setting the benchmarks as a potential liability....

Actually, every bank that engaged in manipulating the benchmark interest rate is exposed to a potential liability that would render them insolvent.

The FSA letters have ruffled feathers, with some industry officials perceiving them as strong-arm tactics. 

In one letter, the FSA left the impression among one bank's executives that pulling out of Libor would damage its relationship with the FSA and could negatively influence the bank's standing in the agency's ongoing investigation into rate manipulation, according to a senior bank executive who read the letter. 

The executive said the letter's blunt tone caused the bank to drop its plans to withdraw, at least for now....