Can LIBOR regain credibility?

The very existence of the London Interbank Offered Rate (Libor) has been threatened by the escalating scandal involving banks allegedly manipulating the rate during the credit crisis.

 

The credibility of the benchmark, which has been in place for nearly three decades, and affects everything from the survival of the world’s biggest banks to interest rates for ordinary savers, has been dented. Ben Bernanke, US Federal Reserve chairman, told Congress Tuesday that it is “structurally flawed.” International efforts to reform the benchmark rate are underway.
The revelations about artificial lowering of the rate, which helped mislead markets about banks’ willingness to lend to each other, have already claimed the job of ex-Barclays Chief Executive Bob Diamond. More scalps are likely to follow as the investigation continues.
So, will Libor itself be killed off? Or can it survive in a different form

Totally eliminating the rate, which is used to set rates for an estimated $800 trillion of derivatives and debt, sends shivers down spines in London and Wall Street.
“The size of the markets which reference Libor is so large that to abandon or radically alter it would cause unpredictable consequences,” Laurence Mutkin, European interest rate strategist at Morgan Stanley, pointed out.

A new futures contract known as the GCF (“General Collateral Financing) Repo Index Futures, launched on Monday and traded on NYSE Euronext, has been touted as a possible alternative, but pessimists believe that it is too short-term to reflect the overall tone of the market.
The British Bankers’ Association was already considering changing the way Libor was set before the scandal erupted – and this consultation has been made more urgent by recent events.

How to Fix Libor

What exactly can be done to fix the Libor system or is it worth fixing at all? Catherine Boyle has more.

 

At the moment, Libor is set at around 11am London time, when the banks involved in the panel which set it send the rate at which they are lending money to other banks to Thomson Reuters, via a secure network. The highest and lowest quartile rates are removed and the average of the remaining rates becomes Libor.

This basic model is followed by other inter-bank lending rate-setting panels around the world, who will doubtless be watching London closely. Several banks have quit these panels in recent days as the Libor fallout grew. Royal Bank of Scotland , for example, has left the panel which sets the Libor equivalent in Tokyo, Hong Kong and Singapore. If banks continue to drop out of setting the rate, this could itself cause its demise.

One point in Libor’s favor is that it does, with notable exceptions such as during the US sub-prime crisis, generally reflects what is in the market, as Mutkin points out. Another is that it is useful for market stability to have a benchmark rate based on three-month rather than less stable day-to-day lending.

Mutkin believes that part of the problem is that the Libor panel is just not asked the right question to reflect market realities.

“The Libor panel question as it now stands could well be re-phrased as: ‘At what rate would you do a transaction which you haven’t used much for funding during the past 20 years, and which Basel regulations discourage you from doing?’” he wrote.

The key message from London sources is that for Libor to regain credibility, it will have to become the basis for real transactions. Roughly speaking, it has to be real rather than conceptual.

One suggestion is the bank which submits the lowest rate to the panel should then be obliged to lend a set amount of money at that rate to other banks. The amount should be substantial but not enough to materially affect the bank.

The BBA could also use more up-to-date technology than the current secure network to take the Libor sample. If all Libor transactions were monitored by a single mechanism which then took an average, this argument goes, banks wouldn’t be able to fix the rates at an artificially low or high rate.
Broadening the sample beyond the 15 banks currently used to set the euro rate (the sterling panel has 16 banks and the dollar 18) is another option. Or the rate could be set by a new body rather than the BBA.

Whatever the eventual solution, the message coming from trading desks around the financial sector is that change is inevitable

Internal Polical Risk

Banks regularly take active measures to manage and minimize risks that are inherent in our industry. These include credit risks, interest rate risks, operational risks, compliance risks, legal risks and even reputational risks. 

However, I believe there is one key risk that is the most neglected risk of all from a performance management standpoint: internal political risk.

What is internal political risk? It's a very weak operating culture, and it results from ongoing and unsettled disputes among different departments and individuals within the bank. Poor communication and weak leadership are to blame, as it nurtures the constant quarreling, disgruntled relationships and failure to fulfill organizational goals.

I have noted in my years of experience that few banks have a truly effective culture, while the rest are inhibited by selfish attitudes and organizational ineffectiveness. Banks must take a stand against this shattered culture syndrome or suffer the repercussions of a fractured chain of command, low employee morale, reduced productivity, high employee turnover, weak customer service and poor work quality.

Establishing a solid operating culture starts at the very top of the organization. The board of directors and senior management must come together to define the values and characteristics the bank intends to operate under and grow with long term. More specifically, values need to be integrated with shared beliefs and a powerful business mission into an energizing narrative that uniquely positions the bank for growth and profitability. Without this integration, real change is unlikely to occur, leaving the bank to continue floundering in a toxic culture that will undoubtedly preclude it from reaching its full potential.

Once a cultural framework is established and corporate values are identified, a detailed plan can be constructed to fully immerse all relevant parties in the new culture.  Coordinated, purposeful and comprehensive internal communication must be established to signal to the staff that a meaningful cultural change is underway.  A key element of this plan may be a companywide employee engagement event focused on getting staff to also serve as brand advocates. This will instill a strong sense of employee pride in the organization and build a deeper emotional connection between the employee and the bank.

Additionally, efforts to reward sound values and behaviors, in the form of an established employee recognition program, can contribute to strengthening your culture. In my opinion, these steps counteract the most widespread banking industry weakness:  a lack of accountability for results
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I urge you to actively and thoughtfully design the culture you want, one that promotes your values, teamwork, customer satisfaction, innovation, change, accountability, employee achievement and effective communication. Build it into your branding and marketing efforts. Feel and see the difference. Make the message of your strong culture resonate profoundly with your customers.  Keep it vibrant, trendy, topical and fresh.  Make it fun.  Renovating your bank's culture will elevate your bank's performance.  And in the process, you will have one less risk to worry about.         

Economics Today

There is an old story from the heyday of the Soviet Union. As part of their May Day celebrations they were parading their latest weapon systems down the street in front of the Kremlin. There was a long column of their newest tanks, followed by a row of tractors pulling missiles. Behind these weapons were four pick-up trucks carrying older men in business suits waving to the crowds.

Seeing this display, the Communist party boss turned to his defence secretary. He praised the tanks and missiles and then said that he didn't understand the men in business suits. The defence secretary explained that these men were economists and "their destructive capacity is incredible".

People across the world now understand what the defence secretary meant. The amount of damage being inflicted on countries around the world by bad economic policy is astounding. As a result of unemployment or underemployment, millions of people are seeing their lives ruined. The current policies have led to trillions of dollars of lost output.

Bad policy

From an economic standpoint this loss is every bit as devastating as if it building had been destroyed by tanks or bombs. And people have lost their lives, due to inadequate healthcare, food and shelter, or as a result of the depression associated with their grim economic fate. 

If an enemy had inflicted this much damage on the United States, the countries of the European Union, or the countries elsewhere in the world that have been caught up in this downturn, millions of people would be lining up to enlist in the military, anxious to avenge this outrage. But, there is no external enemy to blame. The villains are the economists, still mostly men, in business suits.     

 The New York Times reported last month that formerly middle class workers in Spain are now picking through dumpsters looking for food. There are similar accounts from Greece. Both countries have unemployment rates hovering near 25 per cent, with youth unemployment rates that are nearly twice as high. 

And, the expectation is that things will only get worse. The latest projections from the IMF show the economies of both countries continuing to shrink through the rest of 2012 and for the whole of 2013. It is also important to remember that the IMF's growth projections have consistently been overly optimistic.

There are similar stories across the euro zone and now also in the United Kingdom as that nation's leaders have pursued economic policies that have thrown it back into recession. And of course the US is also losing close to $1 trillion in output each year, with close to 23 million unemployed, underemployed or out of the workforce altogether because of poor job prospects.

The economists in policy positions are doing their best to convince the public that the economic catastrophe that they are living through is a natural disaster that is beyond human control. But that is what Vice-President Biden would call "malarkey". This is a disaster that is 100 per cent human caused and is being perpetuated by bad policy.

 Social wreckage

The original collapse was the result of central bankers who were at best asleep at the wheel, or at worst complicit in the financial sectors' wheeling and dealing, ignoring the risks that massive housing bubbles obviously posed to the economy. However, the response to the downturn has made a bad situation far worse than necessary.

 As the evidence keeps telling us, the basic story is about as simple as it gets. The housing bubbles were driving demand prior to the collapse both directly through building booms and indirectly from the consumption generated by bubble generated housing equity. When the bubbles burst the construction booms went bust. And when the bubble generated housing equity vanished so did the consumption for which it provided a basis.

The basic economic problem in this context was finding a way to replace the lost demand. The right-wing politicians and their allied economists can repeat all the nonsense the like about promoting business confidence and tax breaks for job creators, but there is no remotely plausible story in which it would be possible to generate enough demand from investment to make up for the demand lost from the collapse of the bubbles.

 This means that in the short-term the only way to make up the demand is from the government budget deficits. This is not even economic theory, it is simply accounting.

In the longer term, the shortfalls in demand will have to be made up from a rebalancing across countries. Countries with large trade deficits, like the United States, Greece and Spain will have to move toward more balanced trade.

 In the case of the US this can only plausibly be done with a decline in the value of the dollar. In the case of the euro zone, there is no plausible alternative than to have the surplus countries, most importantly Germany, have more rapidly rising wages and prices in order to allow the deficit countries to regain competitiveness.

All of this is pretty straightforward, but the economists are instead steering the world toward more years of stagnation and rising unemployment and poverty. The human and social wreckage they have caused puts our enemies to shame. 

Bonds

What are Bonds?

A bond is simply a long-term loan. Most people have at some stage applied for a loan at a bank and had to pay interest on the amount of the loan. The bond market operates in exactly the same way. A bond is a financial instrument that promises that the borrower (a company or a government) will pay the holder (investor) interest over a period of time and repay the full amount of the loan on a predetermined maturity date. Just as people need money, so too do companies and governments.

Why invest in Bonds?

Bonds provide investors with a regular and steady income in the form of interest while preserving their initial investment amount (principal). They can help investors spread assets across different asset classes of the financial market, thereby minimising the risk of concentration in any one asset class. Bondholders usually have priority over stockholders when a company is liquidated and more likely to receive payment. Bonds are usually evaluated and rated based on credit history and ability to pay interest and repay obligations on time.

How to invest in Bonds

Investors can buy and sell bonds through a broker, just like shares. If you are not already a client of a broker, you will be assisted by your broker to set up an account and transact with a minimum delay. Your broker will be able to offer you advice and trade on your behalf.