Monday, July 9, 2012

Holman Jenkins Gets the LIBOR Scandal

He writes in WSJ:
Libor was flawed by the assumption that the banks setting it would always be seen as top-drawer credit risks. The Basel capital-adequacy rules were flawed because they incentivized banks to overproduce "safe" assets, like Greek bonds and U.S. mortgages. The ratings process was flawed eight ways from Sunday, including the fact that many fiduciaries, under law, were required to invest in securities blessed by the rating agencies.

Some Barclays emails imply that traders, even before the crisis, sought to influence the bank's Libor submissions for profit-seeking reasons. This is puzzling and may amount to empty chest thumping. Barclays's "submitters" wouldn't seem in a position to move Libor in ways of great use to traders. Sixteen banks are polled to set Libor and any outlying results are thrown out. Plus each bank's name and submission are published daily. But let's ask: Instead of trying to manipulate Libor in a crisis, what would have been a more straightforward way of dealing with its exposed flaws, considering the many trillions in outstanding credit tied to Libor?

The answer is obvious: The Bank of England might have stepped forward with a statement: "All banks are potentially insolvent. Therefore, Libor is no longer an effective proxy for credit availability to top-notch borrowers. Therefore the government is instituting price controls over Libor and the benchmark will be set by administrative fiat until further notice."

This would have been an aboveboard solution. It would also have drawn back the curtain on the wizard in a way perhaps not helpful to central-bank efforts to contain an incipient financial panic. In a budding panic, the wizard act of monetary authorities is all we've got. You haven't understood the Libor scandal until you understand this part too.

In this comment, Jenkin's makes a number of important observations that have deeper meaning than perhaps he even realizes.

The first being that LIBOR, like the eurozone is a flawed man-made construct. Using market forces are much better ways to come up for solutions in both cases.

The Basel capital-adequacy rules were flawed because governments, as they always will, directed banks to invest in financial instruments that will benefit governments.  No sane bank would have their  portfolios structured the way LIBOR banks did, without regulations forcing them to move in such a direction.

It would be pretty difficult to really game the LIBOR even from a technical perspective, aside from the fact that it is also absurd to think that bankers would be able to manipulate world rates in the first place---without seeing huge distortions in the supply and demand for loans across the globe.

 "All banks are potentially insolvent" not only during a crisis, but at all times given the fractional reserve system under which banks throughout most of the world operate under. The solution is not interest rate controls instituted by the BOE, which would lead to even more distortions in the markets, but the closing down of the BOE, the liquidation of banks who can't meet their obligations (which would be most English banks) and allowing sound banks to emerge via the free markets.

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