The New York Federal Reserve Bank released on Friday about 100 pages of emails and internal documents from both its own staff and Barclays concerning the LIBOR fixing problem. The redacted Barclays documents cover parts of 2007 and 2008 and while the FRB NY documents cover only 2008. It is tempting to jump to conclusions about what did or did not happen and why, but there are still some missing pieces of the puzzle and the FRB NY has not been as forthcoming as it might have been, as will be detailed below. Some commentators are already criticizing Treasury Secretary Geithner’s handling of the events while he was president of the Federal Reserve Bank of New York. We will clearly learn more when he and Chairman Bernanke testify on the issues. For now it is important to look first at the evidence that is now available and try objectively to sort through the issues as they now appear. For this author, who was a former Federal Reserve Bank of Atlanta official, it is hard to maintain a totally unbiased view on the issues, but we’ll try.
Fact number one is that questions about the LIBOR fixing and its process have existed for a long time. Potential problems with the structure of the LIBOR fixing process were examined by a Federal Reserve Board staff member as far back as 1998 (See Jeremy Berkowitz, “Dealer Polling in the Presence of Possibly Noisy Reporting,” Federal Reserve Board, 1998). The process is clearly flawed since it isn’t based upon actual transactions and the structure is prone to incentive conflicts that are obvious and should have been corrected by the British Bankers Association (BBA) years ago. Berkowitz’s research suggests that as few as four inaccurate submissions could bias the reported rate. Others have shown that the rate could be manipulated, with even one biased submission. The whole fixing process has a clubby tone that one might expect when a trade organization is responsible for compiling and releasing a key interest rate statistic on behalf of its constituents. That system relies upon trust and honesty that can be challenged when money and earnings pressures exist, and a trade group is not in a strong position to either police or correct the behavior of its members. That organization bears a heavy responsibility for the current problems and raises the issue of whether the process should be taken over by the Bank of England or some other responsible unbiased authority. Indeed, even after the scandal broke, the BBA website continues to contain two substantively different descriptions of what the LIBOR actually is.[1]
Fact number two is regulators were aware of possible anomalies in the daily submissions, and when brought to the attention of the British authorizes, namely the Bank of England, as a result of a 2008 Wall Street Journal article, nothing was done, and minimal actions appear to have been taken even when Mervin King, Governor of the Bank of England, was presented with a set of recommendations by the Federal Reserve Bank of New York. Reportedly the Bank of England did forward the Fed’s recommendations to the BBA, but no changes were made in response.
Fact number three is that staff members in the Markets Group at the Federal Reserve Bank of New York, were clearly well aware of problems with LIBOR postings, particularly in the dollar LIBOR rate, long before it was apparently brought to the attention of then President Geithner. Transcripts of conversations between staff of the Markets Group and Barclays staff as early as December of 2007 raised questions about the LIBOR fixing and a subsequent April 2008 transcript of conversations contained admissions of intentional misstatement of the rate by Barclays and possibly by others. The tone of the transcript conversations raises a cultural concern. Both parties to the conversation viewed themselves as part of a closed market in which the exchange of information was freely given with little concerns for confidentiality or the risks that such discussions might be viewed by an outsider as inappropriate.
In assessing these conversations, it is important to understand the role of the Markets Group, how it fits into the NY Fed, and what its function is for the FOMC. The Group reports to the Manager of the System Open Market Account who is responsible for managing the day to day transactions with the Primary Dealers as part of its responsibility to keep the Federal Funds Target interest rate where the FOMC has directed. Each day, there is a telephone call involving the staff of the Markets Group, members of the Division of Monetary Affairs of the Board of Governors and one of the presidents who is a voting member of the FOMC. There is a briefing on market developments during the previous day and in overnight foreign financial markets, most, if not all, of which is irrelevant to the decision to be made that day on the volume of securities or repo transactions to be undertaken. The daily program is most heavily influenced by Treasury balance conditions, draws on the Treasury tax and loan accounts and events that might have affected the flow of payments through the payments system, all of which could influence the reserve positions of banks that day. It would be interesting to know whether any questions were raised in the course of the daily phone discussions, which may or may not have been recorded, about the efficacy of the LIBOR fixings and what if any such concerns might have been transmitted to the FOMC.
The Markets Group is mainly a market monitoring group and does not have, nor does it perform market regulatory functions, although it does provide several other types of services to the Treasury as well as other central banks. The Manager is appointed by the FOMC, but the Group and the Manager are lodged within the FRB NY, and technically report to the bank’s First Vice President, but the Group essentially operates autonomously. In addition, it is totally separate from the NY Bank’s supervisory staff and does not conduct institutional surveillance activities. Whether it should or not, is another matter and relates to the relationship between the Markets Group and the primary dealers with whom it transacts its daily open market activities.
The Primary Dealers are central to the transmission mechanism of monetary policy under the current structure and there is a close relationship between those dealers, the Desk, and the Fed as the numerous emergency liquidity support mechanisms put in place to keep the dealers afloat during the financial crisis demonstrate. There is clearly a symbiotic relationship between the Desk and the primary dealers, of which Barclays was but one - a relationship that one would not characterize as a regulatory or supervisory relationship. In fact, we have noted in earlier writings, in 1992 the NY Bank, under President Gerald Corrigan, expressly orchestrated a pull- back by the FOMC in the Desk’s surveillance of the primary dealers because of the belief that the relationship between the Desk and the dealers conveyed upon them an implicit subsidy that was viewed as being inappropriate. Subsequent events during the financial crisis, however, revealed that the subsidy and special position did indeed exist, but in the absence of oversight.
One other point is worth mentioning. Although the Manager of the Desk customarily makes presentations on general money market conditions to open each FOMC meeting, review of publicly available transcripts would suggest that these presentations were at best tangential to monetary policy discussions or its formulation. Those transcripts suggest that LIBOR, its structure and role in financial markets, did not play a central or critical role in the presentations. We don’t know if that was true during the financial crisis period because those meeting transcripts are not yet public. But given that during the period between the fall of 2007 and the fall of 2008, the Fed viewed the strains in financial markets as mainly due to liquidity issues rather than solvency problems, the concern would have been mainly on how information was or was not being processed by the market rather and whether reported rates might generate runs on the dealers rather than concern about how the LIBOR was being fixed. Again, there is room for more transparency on this point by the Fed. Also, it suggests that there may be an inherent regulatory conflict between concerns about market stability and the rights of investors and borrowers whose costs of funds and returns could have been significantly affected by miss-reported rates. Again, the available information suggests that institutions’ traders had the necessary incentives and actively tried to influence LIBOR fixings to affect their own profit and loss positions. This issue was the subject of a 2009 paper by Snider and Youle who provided estimates of what the potential gains might have been to LIBOR submitting institutions (See Connan Snider and Thomas Youle, “Diagnosing the LIBOR: Strategic Manipulation and Member Portfolio Positions,” December 2009, https://www.econ.umn.edu/~bajari/undergradiosp10/LiborManipulation.pdf).
Fact number four, which is actually missing, is information on where within the submitting institutions the LIBOR fixings originate. This information is important because it may help to highlight what is emerging as another example of problems associated with regulatory overlap and conflicting jurisdictions when institutions operate cross-border. Presumably, for UK and foreign banks, the submissions would either come from their home offices or London offices. For UK institutions, this is clearly the case, and as such their submissions are obviously a UK matter. For US submitting institutions, we don’t know whether the submissions emanated from NY or from the institutions’ London offices. If the former, then there may be some justification for concern on the part of the NY Fed about those submissions, but given the institutional structure and split between the Markets Group and other parts of the NY Fed it is not clear when and how the submission issues would have been raised. In that regard, some detail on how the issue finally got to then President Geithner’s desk and the thinking behind Geithner’s letter to the Bank of England’s King is relevant. If the submissions came from the US banks’ London offices, then again, the issue is first and foremost a problem for the BBA and Bank of England. As for the conversations between the Markets Group staff and Barclays, again it is relevant to know where the staffs were located. If they were in the UK, then the problem was first a UK issue. If the staff were in Barclays NY office, then the conversations were presumably second hand accounts of what was being done in the UK. Again, this does not at first blush seem to be a US issue.
These are but a few of the additional questions that come up as the slow release of information on the LIBOR fixings come out. For right now, some tentative conclusions seem appropriate. First, the UK must fix how LIBOR is set and perhaps the Bank of England should take the activity over from the BBA which is clearly done a poor job. Too many decisions and financial interests of too many borrows and lenders are at stake for the present system to continue as it is. Second, we still don’t know much about what the US regulatory involvement was or was not. As a side note, while the Fed may have lacked the authority to intervene or to police the LIBOR fixing, two things are clear. It could have used its leverage through the primary dealer system but didn’t to get more information on the LIBOR submissions. Also, the Dodd-Frank legislation has clearly broadened the authority of US regulators to monitor and police markets in addition to institutions. Little has been done on this front and the responsible agencies need to be pushed. Finally, if it wasn’t clear before, it is now, that the FOMC’s 1992 decision authorizing the Manager of the System Open Market Account to cease its surveillance activities was a huge mistake and should be revisited. We are sure that more issues will surface as time goes on and we will continue to amend and expand upon our observations and more facts become available.
[1] On the BBA LIBOR home screen it states that “It is calculated each day by Thomson Reuters, to whom major banks submit their cost of borrowing unsecured funds for 15 periods of time in 10 currencies.” However, when one looks at the actual question to which the banks are asked to respond, it is clear that the submitted rate is not an actual transaction rate. The question asked is “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” This is followed by … “bbalibor is not necessarily based upon actual transactions…”
