LIBOR: Looking Forward, Looking Back

by: Craig Pirrong

A couple of LIBOR-related items:

1. Timmy! claims that he and the FRBNY were "very forceful from the beginning" in dealing with LIBOR manipulation. This is an example of why Timmy! (AKA Rodney Dangerfield) gets no respect. His letter to the Bank of England (BOE) was a classic example of bureaucratic CYA and buck passing. The BOE then exchanged the buck and passed the pound to the British Banker's Association (BBA) which did . . . nothing. More nothing happened for over three years, and it wasn't the Federal Reserve Bank of NY (FRBNY) that drove the process. The scary thought is that is what passes for forceful in Timmy!'s world. The scary alternative is that Geithner is just BSing about his past forcefulness. The thought that Geithner's 2008 actions were forceful is Pythonesque, really:

Cardinal Ximinez: Cardinal Fang! Fetch… the Comfy Chair!
Cardinal Fang: [horrified] The Comfy Chair?
[Fang scuttles off, then returns with the Comfy Chair and sits the old lady down in it]
Cardinal Ximinez: Now, you will sit in this c;hair until lunchtime, with nothing but a cup of coffee at 11!

2. Central bankers are looking for an alternative to LIBOR, EURIBOR, etc.

Central banks are exploring whether financial markets might be steered to adopting benchmarks other than Libor. Mr. Bernanke suggested a few alternatives at his hearings this week. Among them: The rate that financial institutions charge each other for short-term loans in "repo" markets in which they use their large securities portfolios as collateral for short-term loans. He said derivatives markets also provide alternatives, such as "overnight index swap," or OIS, rates, which track central bank lending benchmarks.

That's great going forward, but what about the $800 trillion or so in notional and/or principal amount of outstanding derivatives, loans, and other financial instruments with payments tied to LIBOR and its European and Asian cousins? That would be a helluva lot of contracts to orphan.

LIBOR needs to be fixed because of this massive amount of legacy contracts. But how? It won't be easy, since the transactions that LIBOR et al should be related to-- unsecured interbank transactions--aren't orphaned, they're damned near extinct. Any decree by regulators that henceforth LIBOR should be something different than the creature that existed at the time these contracts, loans, etc., were created would potentially result in the shift of many billions of dollars of wealth, and spawn intense legal challenges. (Ironically, any fines or damages arising from LIBOR manipulation-related legal actions will weaken banks and make the return of unsecured lending all the more remote a prospect.)

Looking for a replacement going forward is the easy problem. Market participants have an incentive to come up with something more robust. There will be experimentation and competition, and perhaps with a little regulatory shepherding, in not too long, something better (no doubt some sort of secured rate) will emerge as the benchmark. Going forward, market participants can find transactions and benchmarks that are mutually beneficial. That provides an incentive to get it right.

Finding a way to deal with the legacy of the past is going to be a much, much more difficult problem. The primary effects of changes will be redistributive, rather than creative. This will give rise to massive rent seeking and legal conflict. Much fun will be had by all. Especially the lawyers.

Disclosure: None