LIBOR (and other mythical beasts)

Martin Wheatley, British fin­an­cial reg­u­lator charged with solving the LIBOR crisis, has re­turned from his Crusade car­rying, we are told, a splinter of the True Cross which he as­sures us is cap­able of pro­curing mir­acles. Not common or garden mir­acles in­volving the lame, Galilean fish stocks, or talking asses, no. Something really im­pressive: an­noun­cing the ac­tual in­terest rate at which banks are ac­tu­ally pre­pared to lend to each other in a given currency.

Rumour has it that the col­lege of bishops meeting at a secret loc­a­tion in England this week only had the choice of a new arch­bishop of Canterbury as a plenary filler between ec­static ses­sions de­bating the ecu­men­ical im­port of this rev­el­atory oc­cur­rence. Goldman Sachs might be “doing God’s work”, but is Wheatley the Baptist, come to usher in a new uni­versal re­li­gion founded on the ul­ti­mate art­icle of faith — the re­sur­rec­tion of LIBOR after its cru­ci­fixion at the hands of our modern Romans?

Shall we adopt the hy­per­bolic pos­ture and poke our grubby di­gits in those fes­tering wounds?

A re­minder: LIBOR (the London Interbank Offering Rate) is im­portant primarily be­cause it stands as the in­terest rate for some­thing like USD50tn of fin­an­cial con­tracts. The simplest case is the floating rate credit agree­ment. This is a loan agree­ment which states that in­terest is pay­able on the loan amount at a rate which varies in line with the LIBOR rate, plus the lending bank’s profit on this par­tic­ular deal and any man­datory costs. LIBOR is sup­posed to be a cal­ib­rated av­erage of the rates that a se­lect number of banks would lend to each other in the London money market, a market that ex­ists so that banks can find cash quickly to lend on, without having to go out daily and find de­pos­itors the old-​fashioned way. Note that just be­cause we are speaking about London does not mean we are only dealing with ster­ling; there is dollar LIBOR and Euro LIBOR and seven other de­nom­in­ated rates too. Just to add to the mix, we also note EURIBOR, the rate put to­gether by the European Banking Federation. This will be rel­evant in due course.

LIBOR data is col­lated, as we all now know, by the British Bankers’ Association (“BBA”), which phones round the se­lected banks everyday and asks them to quote their im­pres­sion of their cost of funds in the in­ter­bank market. In other words, if today they wanted a few mil­lion for say three months in the in­ter­bank market, what in­terest rate would they ex­pect to have to pay on that amount.

As we also all know now (though a lot of people knew be­fore), Barclay’s and al­legedly others sep­ar­ately were:

  • making sub­mis­sions which formed part of the LIBOR and EURIBOR set­ting pro­cess that took into ac­count re­quests from Barclays’ in­terest rate de­riv­at­ives traders. These traders were mo­tiv­ated by profit and sought to be­nefit Barclays’ trading positions;
  • seeking to in­flu­ence the EURIBOR sub­mis­sions of other banks con­trib­uting to the rate set­ting pro­cess; and
  • re­du­cing its LIBOR sub­mis­sions during the fin­an­cial crisis as a result of senior management’s con­cerns over neg­ative media com­ment.1

The con­sequence, es­pe­cially as a result of the ma­nip­u­la­tion during the Credit Crunch, was a LIBOR rate that was pos­sibly lower than it should have been. The prob­ab­ility of this in­creases con­sid­er­ably if banks other than Barclay’s were also ma­nip­u­lating their quo­ta­tions, be­cause the BBA ig­nores out­liers for calculation.

For those won­dering why lower in­terest rates should be a problem — I mean, why is it bad if people were being de­ceived into paying less in­terest — one an­swer is the nature of floating credit agree­ments: they are al­most in­vari­ably ac­com­panied by man­datory hedging con­tracts which pro­tect bor­rowers if rates go too high, and pro­tect banks when rates go to low. So ac­tu­ally low rates con­vert into bor­rowers paying out more on the in­terest rate swap. Feel free to provide your own cliché here.

What is in­ter­esting for me about the Credit Crunch ma­nip­u­la­tion was that everyone I know knew it was going on by cir­cum­stan­tial evid­ence and hearsay, and in­deed it was so well-​known that no one even con­sidered it might be fraud­u­lent or a reg­u­latory of­fence. The reas­oning was simple: banks had to talk down their cost of funds be­cause the lamest gazelle was going to be the next Lehman Bros for the shorting hedge funds. It is in these cir­cum­stances that it is no sur­prise that we hear (via the U.S.‘s Tim Geithner) that ma­nip­u­la­tion was known to the Bank of England, and in­deed Bob Diamond’s de­fence amounted to saying he was tapped on the shoulder and given a knowing wink by the BoE. This was a case of “market sta­bility” being used to trump the rule of law, as I have noted before.

And market sta­bility in a dif­ferent guise has been driving the in­vest­ig­a­tions into LIBOR ever since. This time it is market sta­bility in the sense of re­taining LIBOR’s pree­m­inent po­s­i­tion as the key rate in the key money market that is the City of London. And we need not pick apart the res­ults of Martin Wheatley’s in­quiry to see that main­taining market pree­m­in­ence was the sole in­ter­rog­ative ho­rizon for all parties, in­cluding Parliament. Douglas Keenan, an ex-​Morgan Stanley trader, wrote a letter to the Financial Times this summer set­ting out his know­ledge of LIBOR ma­nip­u­la­tion since 1991. He continues:

One of the in­vest­ig­a­tions is being un­der­taken by the House of Commons Treasury com­mittee. I tele­phoned the com­mittee on July 3 and spoke with a com­mittee spe­cialist. I told the spe­cialist about the fore­going and said that I was willing to testify under oath. The spe­cialist seemed ex­tremely in­ter­ested. They said they were to have a meeting about the Libor scandal and would call me back af­ter­wards. I did not hear back, how­ever, so I phoned to ask what was hap­pening. My testi­mony was not wanted, the spe­cialist told me, be­cause it “con­tra­dicts the nar­rative”.2

Wrong kind of facts. It is some­what ironic that an in­vest­ig­a­tion into a fraud based on at­tempts to cover up ob­jective evid­ence of bal­ance sheet risk­i­ness should be sub­ject to ma­nip­u­la­tion which seeks to cover up ob­jective evid­ence of sys­temic risk­i­ness. It is a shame the British people cannot like­wise dis­regard its gov­ern­ment as a stat­ist­ical out­lier, much as American and Eurozone reg­u­lators already do.

Anyway, what is Martin Wheatley pro­posing as a fix for LIBOR?

Well, er, LIBOR of course. But one that only ap­pears to a se­lect few on Pentecost be­fore they pro­ceed bab­bling into the streets. Mr Wheatley’s logic seems to have been that as so many con­tracts rely on LIBOR there needed to be as smooth a pos­sible trans­ition to a new mech­anism of equal standing and quality. Unfortunately this doesn’t exist (IN LONDON!) so it be­comes a ques­tion of re­pairing a broken LIBOR. Mr Wheatley wants to do this by slim­ming down the number of LIBOR ref­er­ence cur­ren­cies to only those which have a real “market” where quoted rates can be iden­ti­fied, then having rate in­form­a­tion col­lated by a gov­ern­ment over­seen in­de­pendent body rather than the BBA. Quotations will still be given by a panel of banks, but they must be with ref­er­ence to ac­tual trans­ac­tions that day, un­less the bank ex­pli­citly states oth­er­wise. New reg­u­la­tions will be en­acted to re­quire banks to be honest. Oh, and there will be a new Code of Conduct, al­though that may be an over­looked cut-​and-​paste from the last use­less fin­an­cial inquiry.

The Financial Times thought this was all great — leading the world with re­form etc. US and Eurozone com­ment­ators and reg­u­lators were un­der­whelmed. The EBF (EURIBOR) sneered that their system col­lated in­form­a­tion from local banking as­so­ci­ations and so was less likely to be ma­nip­u­lated (sub­text “please use our rate”). But that is not the same as saying it cannot be ma­nip­u­lated, and in­deed Barclay’s was ma­nip­u­lating it (see above). More thoughtful ana­lysis pointed out that the Wheatley re­form was simply the fin­an­cial equi­valent of Finnegan’s Wake; a com­plex and giddy journey through prose in which you end up where you started. In particular:

  1. reg­u­la­tions to make banks more honest? They are already there, backed by GBP59m fines. And then there is the fraud act. Why would more reg­u­la­tions work…
  2. …es­pe­cially when banks felt they had Bank of England support?
  3. the re­forms still rely on banks to provide quo­ta­tions, and then it still al­lows bank per­cep­tions of what quo­ta­tions would be.
  4. the re­forms still have no sens­ible mech­anism for dealing with Crunch con­di­tions. Another ex­ample of fin­ance lum­bering on in a changed world.
  5. crit­ic­ally, the re­forms still rely on there being an in­ter­bank lending market. But there isn’t much of one left.

The fifth point was raised in re­marks of Chairman Gary Gensler3 to the European Parliament, Economic and Monetary Affairs Committee on September 24, 2012 in Brussels. Mr Gensler asked the ques­tion: why is LIBOR con­sist­ently quoted at al­most half EURIBOR (see below)?

Mr Gensler con­sidered various mundane factors which you can read in his sub­mis­sion here, but pushed us to­wards con­sid­ering the al­lied ques­tion of why LIBOR rates were so much more stable than credit de­fault swap prices on debt is­sued by the same banks, given re­cent volat­ility (see below — the blue line is LIBOR):

In other words Mr Gensler was po­litely asking the European Parliament to con­clude that, even with banks be­having them­selves, LIBOR is still a com­plete non­sense. Nothing Mr Wheatley pro­poses ad­dresses this problem, and Mr Gensler called for in­ter­bank ref­er­ence rates to be set dir­ectly by ref­er­ence to market data.

The problem with direct ref­er­ence to market data, apart from the fact that USD50tn worth of con­tracts will be fluc­tu­ating like CDS (ouch), is as we have said, that we need a market to gen­erate this data and there isn’t one. That limpid blue line above says to me at least not that banks are still ma­nip­u­lating data (they might be), but more that the banks are still not lending to each other. And why should they when the central banks are throwing cheap cash into the system to keep it all going. In these con­di­tions that falsity of the above fig­ures de­rives from banks having to second-​guess in the ab­sence of real trans­ac­tions. LIBOR has be­come a myth, a chi­maera in the philo­soph­ical sense, even if it ever was a real­istic as­sess­ment of in­ter­bank of­fering rates — more useful to its dis­ciples as an image around which fol­lowers con­tinue to co­alesce; and his­tory will be re­written to fit the de­sired narrative.

Note that the ob­lique ref­er­ence to CDS doing it better is a red her­ring; during the Credit Crunch swaps were as much, if not more so, in­cap­able of being priced as their ref­er­ences for marking to market vanished.

One other solu­tion has been mooted which echoes re­cent sur­prising IMF dab­bling in FD Rooseveltian-​bank breaking (on which more in a later post). This is to take the problem of ma­nip­u­la­tion and to em­brace it: shut down the mal­func­tioning money market and simply have the central bank mono­pol­ising the set­ting of (L)IBOR as it does the base rate, in the state’s in­terest. This is LIBOR ma­nip­u­la­tion, but sanc­tioned and pur­portedly in everyone’s in­terest. However, if one was to take that step, one might just as well go the whole hog and im­ple­ment the Chicago Plan (mk#1).

Mr Wheatley’s pro­posals are as far from doing that as LIBOR is from the real world.

Show 3 foot­notes

  1. FSA Final Notice FSA/​PN/​070/​2012 27 Jun 2012
  2. Financial Times 27 July 2012
  3. US Commodities and Futures Trading Commission

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