Nuts and bolts of the Wheatley Review on LIBOR

On Friday September 28, 2012, the UK Treasury published the Wheatley Review, a study completed by Martin Wheatley of the FSA (and soon to be Chief Executive of the UK’s Financial Conduct Authority) on the state of LIBOR. The initial intent of the study was to assess how LIBOR should be reformed and governed, how LIBOR abuse should be sanctioned and what other policy considerations should be made for other financial price-setting mechanisms. The study completed its mission and some aspects are damning of the current regime. This article looks at the parts of his recommendations that securities finance readers would care about most.

By now the press has reported all the basics: the BBA has lost oversight; LIBOR must be reformed and not killed off outright; falsifying submissions is a crime. Here are some additional details from the Review:

“First, the Review has concluded that there is a clear case in favour of comprehensively reforming LIBOR, rather than replacing the benchmark.” Too much change at once could damage he integrity of financial markets, particularly in regards to the trillions in contracts that rely on LIBOR today. We can agree with this, as the logistics of changing the legal agreements alone would be almost incomprehensible. The Review advocates a phased out approach.

“Second, the Review has concluded that transaction data should be explicitly used to support LIBOR submissions.” Further, only LIBOR transactions with enough transaction data by currency and tenor should be included. The Review’s data show that there are a limited number of currencies and tenors where there is a “high activity” of transactions; this will reduce the number of LIBOR benchmarks published from 150 to 20 at current liquidity levels.

“Third, the Review has concluded that market participants should continue to play a significant role in the production and oversight of LIBOR.” That’s fine – banks will continue to send in their figures and oversee the process with final FSA supervision and approval. All banks will be encouraged to participate in LIBOR rate submissions.

These conclusions are all fine and well, but the report gets onto shakier ground when it discusses what is wrong with LIBOR versus how to fix it. The basic problem is that LIBOR is based on bank judgments about submissions and not actual rates. The Review knows this and says that the number of rates should be reduced to only publish those with the most liquidity. As the report says, “the shortening in the maturity of unsecured inter-bank lending markets, along with the increasing extent to which banks’ borrowing is overnight and collateralised, may mean that the assumption of a permanent and deep inter-bank market for term, as originally envisaged by the LIBOR user, is no longer correct.” We wonder where the line in the sand is for enough liquidity in LIBOR transactions to make a call on a judgment-based submission. The Review isn’t asking for only transaction-based benchmarks yet, recognizing that this would be too disruptive. But, improvements have to be made.

This liquidity issue is a fundamental benchmark problem and one that we have discussed frequently. It is also a problem that neither the FSA nor the UK Treasury can readily fix; this is part of the global evolution in bank funding patterns that we have seen since 2008. At one time when banks had extra cash, didn’t mind locking the cash up for term, and the unsecured inter-bank credit lines were available, there was an active inter-bank lending rate that LIBOR submissions could be based off of. The same problem exists in the Fed Funds market, where liquidity has taken a hit from IOER and the FDIC insurance bill.

Things get easier when the report covers the expected trajectory of regulatory oversight, working with international partners and the like. It ends with the expectation that international partners will come up with a framework for improving all sorts of benchmarks. In our next post we will tackle the Review’s ideas on To LIBOR or Not to LIBOR, or, what are the alternatives to LIBOR.

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