The American Enterprise Institute (AEI) convened a panel of experts to review proposals for the resolution of a decades-old controversy over the manipulation of Libor, the benchmark interest rate that serves as the basis for countless loan contracts and derivatives.
Alex Pollock, resident scholar at AEI and former CEO of the Federal Home Loan Bank of Chicago, began the event by explaining that Libor is probably the most important index in the world, but ironically, it is not set in the United States but in London. Even after proposed reforms, it would still be set in London and regulated by the U.K. government.
According to Pollock, this circumstance arose as a result of unwise U.S. actions in the 1960s as the government struggled to maintain a peg of the price of gold at $35 per ounce. Now, he noted, the dollar is worth 1/1,750th of an ounce of gold, and the price is still set in London.
Loans have been priced at euro-dollar rates, and swaps came into widespread use in the 1980s. Being a big U.S. or U.K. bank was once assumed to represent top credit, so Libor was supposed to stand for a top-quality, risk-free rate for top borrowers, but it became a rate for troubled, even insolvent, banks, and it has become an index for troubled borrowers, as well. Pollock asked whether Libor can be replaced by another index that would measure top credits, who would regulate it, whether Libor should be reformed and how any reform would affect rates on mortgages, which are the largest market next to government securities.
Robert Eisenbeis, chief monetary economist of Cumberland Advisors, who formerly served as head of research at the FDIC, provided additional background on the Libor crisis. He pointed out that the Shadow Financial Regulatory Committee had developed a set of proposed reforms before the U.K. authorities did. It is a circumstance that has been festering for some while.
In 1998, the Federal Reserve released a study that began to raise questions about the rate and how it was structured, and as early as 2005 there was evidence that Barclays had tried to manipulate both the rates of the dollar and the euro, and the bank made over 200 requests to fix the Libor.
The Federal Reserve Bank of New York expressed concerns in 2008, as did an article in The Wall Street Journal. But not much was done. There are questions about the testimony of Paul Tucker, deputy governor of the Bank of England, and there are ongoing investigations in many countries, including 10 in the United States by various agencies.
Eisenbeis mentioned two components of the Barclays issue. First, derivatives traders tried to influence the rate in favor of positions they had, and other banks might have also been involved. Second, which crystallized the problem, was an attempt by Barclays in 2007 to report a low rate, perhaps at the urging of the U.K. regulators, to mask its condition in order to ease its funding difficulties.
Some commentators have missed the point that it isn’t who was hurt that is the core of the issue, but rather the ability to improve the results of trading positions by manipulating Libor.
As for responsibility, the British Banking Association (BBA) is in charge, and it hasn’t done much. The BBA website still gives three different definitions of Libor, and the site hasn’t been fixed, despite the controversy. Of the 18 banks whose submissions form the basis of Libor, only two are U.S. banks.
Lastly, in September, the Wheatley report, from the U.K. government, came up with a 10-point plan that mirrors to a large extent the Shadow Committee’s recommendations. Eisenbeis concluded that Libor is too important to financial markets to be abandoned, but it needs to be based on actual transactions, with the BBA getting out of the business of administering Libor, with penalties for manipulation that would be enforced and with transparency as to the basis for the rates.
Among the other panelists, Robert Pickel, CEO of the International Swaps and Derivatives Association, asserted that poll-based methods that survey knowledgeable people “should work just fine,” as long as there is proper oversight and enforcement of the “Chinese” walls that are supposed to separate traders from bankers. His position is that Libor is so embedded in a multitude of contracts that it cannot be abandoned.
One is left to ask why, with all that was at stake, or maybe because of what was at stake, the banking industry did not provide the needed enforcement, and why it can be relied upon to do so in the future once an appearance of normality is restored and the heat is off.
Allan Mandelowitz, former chairman of the Federal Housing Finance Board, presented the argument for using the discounted notes of the Federal Home Loan Bank (FHLB) system as a substitute for Libor. He told the audience that he is developing regression studies showing that under normal market conditions, this method would produce a close substitute for Libor, one that he asserted would not be influenced by policy actions of governmental authorities such as the Federal Reserve.
However, his argument was immediately refuted by Sean Tully, managing director of interest rate products at the CME Group, who said that while the FHLB rate would be appropriate for institutions that can borrow from it, this would not be the case for most of the largest banks. However, the panel did not mention the episode of the FHLB system providing extensive support for Citibank at a critical point in the financial crisis.
Tully then endorsed Pickel’s view that Libor can work if there is better management of the inherent conflicts between the lenders and traders in the largest banks. (Part of such a program might be strict enforcement of a Volcker-type rule against conducting trading activities within the largest financial institutions, but this was not discussed.)
Finally, Mike Moore, an independent mortgage funding consultant, also questioned whether the idiosyncrasies of the FHLB system would make its debt a suitable substitute for Libor, and he added his voice to panelists advocating or predicting that Libor will be left essentially as it is.
However, he acknowledged that “there aren’t as many large, creditworthy institutions as there used to be, and the transactions are no longer mostly unsecured.”
During the Q&A, Eisenbeis remarked that among the eight largest banks in the world, all have some government involvement in their ownership, but Tully responded that the policy of too big to fail has been discontinued under the Dodd-Frank Act, and there was no further discussion.
The synthesis of the presentations is that adjustments will be made in the way Libor is administered, and how well these will work can only be judged after the next crisis episode. An alternative would be to draft contracts for new deals to rely on benchmarks other than Libor.
Robert Feinberg served on the staff of the House Banking Committee for the 10 years that encompassed the savings-and-loan debacle and the beginning of its migration to the banking sector. Subsequently, he has consulted on issues related to the crisis for law firms, accounting firms, securities firms and trade associations.
Feinberg holds a BS.E. from the Wharton School and a J.D. from the Law School of the University of Pennsylvania. He has drafted dissenting views on landmark banking legislation, contributed to a financial blog and written hundreds of reports for clients to document the course of the financial crisis as it has unfolded over the past three decades.
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