In today's WSJ, economist Richard Grossman argues we should scrap the London Interbank Offering benchmark rate (LIBOR). To be sure, as Grossman argues, the LIBOR rate has been plagued by scandal:
Because so much money is riding on Libor, banks have an incentive to alter submissions—up or down, depending on the situation—to improve their bottom lines. Many in the financial community had long known about Libor manipulation. As early as 2008, then-president of the Federal Reserve Bank of New York Timothy Geithnerwarned the Bank of England that Libor's credibility needed to be enhanced. E-mails between bankers that have come to light since the scandal broke almost a year ago prove conclusively that cheating was commonplace.
Instead of fixing LIBOR, however, Grossman wants to scrap it:
The British government should announce that, six months from today, Libor will cease to exist. The British Bankers' Association, which technically owns the interest-rate index, has been so wounded by the scandal that it has been willing to follow the government's lead and will no doubt agree.
And how will markets react? The way they always do. They will adapt.
Financial firms will have six months to devise alternative benchmarks for their floating rate products. Given the low repute in which Libor—and the people responsible for it—are held, it would be logical for one or more market-determined rates to take the place of Libor.
Grossman's argument is fraught with error. First, he far too glibly assumes that markets will easily adjust. But LIBOR is not just used in spot markets, which could adjust in the short term, but is also used in countless long-term contracts. As I explain in my article, Reforming LIBOR, attempting to replace LIBOR with an alternative benchmark likely would have triggered massive dislocation--and, as a result, massive litigation. In addition, the extensive network effects associated with LIBOR suggest that change would be costly due to path dependency.
Second, it's not obvious that there are any plausible alternatives to benchmarks based on interbank lending. Grossman argues that there are at least two:
One often mentioned candidate is the GCF Repo index published by the Depository Trust & Clearing Corp. This index is based on actual repurchase agreement transactions, and is thus a better indicator of the cost of funds than banks' internal estimates—even if those estimates were unbiased. Another option might be some newly constructed index based on credit-default swaps transactions, corporate bonds and commercial paper.
Like other interbank offering rate benchmarks, however, LIBOR submissions combine three components: (1) compensation to the lender for the time value of money, (2) compensation for the risk that the counterparty bank will default, and (3) a liquidity premium reflecting market transaction costs. This combination has proved highly useful for lenders. It allows lenders to pass on changes in their funding costs to borrowers and thus minimize basis risk, for example, by pegging the borrower’s interest rate to LIBOR plus an appropriate risk premium reflecting the borrower’s creditworthiness. As such, if the lending bank’s funding rate rises, so too will the rate the borrower must pay, ensuring that the lending bank will continue to receive the full risk premium. Grossman's alternative index based on CDSs etc... lack those characteristics.
The GCF Repo index also differs from bank funding costs, consisting of "the average daily interest rate paid for the most-traded GCF Repo contracts for U.S. Treasury bonds, federal agency paper and mortgage-backed securities [MBS] issued by Fannie Mae and Freddie Mac." The GCF Repo index also is problematic because it's based on US instruments. One of LIBOR’s major advantage is that the London time zone allows it to straddle the Asian and U.S. markets.
Finally, Grossman ignores the reforms that the UK government has put into place to ensure that the reformed LIBOR benchmark will be less vulnerable to manipulation. Specifically, LIBOR submissions will be based on a hierarchy of transaction types. A panel bank first looks to its own transactions in the inter-bank deposit market, in other deposit markets such as commercial paper, and finally in other related markets such as derivatives. In the absence of good data from such transactions, a panel bank next looks to its observations of third party transactions in those markets. The third tier of the hierarchy consists of third party quotes to panel member banks in those markets. Only in the absence of any such transaction data should a panel member rely on an estimate in making its LIBOR submission.
In order to further strengthen the link between LIBOR and actual transaction data, the number of currencies and maturities for which a LIBOR benchmark is quoted are to be reduced by eliminating currencies and maturities traded in particularly thin markets.
In sum, the case simply has not been made for scrapping LIBOR. Instead, we need to be careful to ensure that the new administrator is well supervised. This is so, because Grossman is right about one thing: NYSE Euronext is a suspect administrator. The BBA failed in large part because it had no skin in the game. NYSE Euronext has the opposite problem; i.e., too much skin in the game:
British authorities earlier this month granted a contract to run the index to NYSE Euronext, a company that owns the New York Stock Exchange, the London International Financial Futures and Options Exchange, and a number of other stock, bond, and derivatives exchanges. NYSE Euronext is scheduled to be taken over by IntercontinentalExchange, a firm which owns even more derivatives markets.
In other words, the company that will be responsible for making sure that Libor is set responsibly and fairly will be in a position to profit like no one else from even the slightest movements in Libor.
The UK regulators will need to closely supervise NYSE Euronext to ensure it doesn't cheat and be prepared to force NYSE Euronext to step aside if necessary. But that's an argument for supervision, not for scrapping the whole project.
