Wednesday, July 11, 2012

Libor Demystified

Via WSJ:

Monday's parliamentary testimony from Paul Tucker, deputy governor of the Bank of England, has done nothing to calm the political furies swirling around Barclays bank and the London Interbank Offered Rate. But the testimony was a useful education in what Libor is, what it isn't, and why this is a lesser scandal than the outrage would suggest.

In one revealing exchange, Tory MP Andrea Leadsom asked Mr. Tucker whether the Bank "required" Libor submissions to be "based on actual transactions." Mr. Tucker took the opportunity to remind the committee that Libor is not an interest rate controlled or even regulated directly by the central bank. Rather, it is an average, or group of averages, calculated by the British Bankers' Association, a private trade body.

Libor was conceived in the 1980s as an indicator of the cost of short-term funding for highly rated banks, and it was in that role that it came to underpin trillions of dollars of derivatives and loans.

But as Mr. Tucker explained Monday, its role changed in 2007 as the financial panic started to bite. "It became," in Mr. Tucker's words, "a measure of something else"—specifically, of the difficulty that those same banks were having in raising money. It was in this unanticipated role that Libor caught the attention of regulators on both sides of the Atlantic during the panic.

After Mr. Tucker's testimony, the Federal Reserve Bank of New York released a statement saying that Barclays had raised concerns about the integrity of Libor as far back as August 2007. At that time, Libor was just starting to be viewed as a measure of financial stress. And because banks' Libor submissions are public, those banks had a newfound interest in demonstrating their strength by putting up flattering Libor numbers—something that everyone seems to agree Barclays initially refused to do.

Today, with the panic behind us, everyone can decry the gaming of Libor. Back then, however, regulators were at least as concerned about the spread between Libor and another instrument, the overnight interest-rate swap index. Historically, the spread had been negligible. But as people started to worry about the banks, that spread became significant—and closely watched. The New York Fed says it took its concerns about the methodology of Libor to the British Bankers' Association. But serious reform was put off until things had settled down.

Via WSJ:
Mr. Tucker made clear that the requirement for "real transactions" that Ms. Leadsom seems to desire would have resulted, at the height of the financial panic, in no Libor rates being reported at all on many days. For months at a time, Mr. Tucker said, nearly all the reported Libor rates were "judgments about where they [the banks] could borrow in the markets." That is, if they were borrowing at all.

This was the core of Mr. Tucker's defense of his controversial phone call with Barclays ex-CEO Bob Diamond in October 2008. In that call, according to Mr. Diamond, Mr. Tucker said that "it did not always need to be the case" that Barclays's reported Libor rates be at the top-end of the range. For this, Mr. Tucker has been excoriated for attempting to manipulate Libor, a charge he "absolutely" denied on Monday (and of which Mr. Diamond also absolved him).

Whatever the subtext of Mr. Tucker's remark, his broader point is undeniable: Libor has always contained an element of judgment, and a degree of fudge. This is especially true when markets are stressed, as they were during parts of 2007 and 2008.

The bipartisan outbreak of market purism in Parliament and the media is refreshing in one sense—never have so many, of such different political persuasions, argued so eloquently for the virtue of unadulterated price signals. Would that these same politicians and journalists always displayed such fealty to the benefits of the market.

But Libor is simply an average, one approximation of a particular price of borrowing. That's not to say it isn't robust: There's a reason that zero hard evidence has yet been put forward that Barclays or anyone else successfully bent Libor to its will. Many of the sophisticated investors who willingly signed contracts tying trillions of dollars of derivatives to the rate grumbled about its imperfections and frailties long before Libor became a political football. But they used it of their own volition because it worked well enough most of the time.

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