LIBOR and Lilliput
Both Gary Gensler and Martin Wheatley, who as today’s Financial Times reports take opposite views on LIBOR (“Libor must be scrapped” and Lombard), are right. Gensler, head of the US Commodity Futures Trading Commission, thinks the index is completely discredited, while Wheatley, head of the Financial Conduct Authority, doesn’t want to scrap it before a proper alternative has emerged. Lombard likens this to the feud between the Big-Enders and Little-Enders, noting that in the end everyone managed to eat their egg. But, as those of you who have been reading this blog (or my evidence to the Wheatley review) will know, there is a way to reconcile these conflicting views. It will also make a major contribution to stabilising banks and giving them a chance of survival without the implicit taxpayer support on which, five years after the crash, they remain wholly dependent.
Everyone seems to have lost sight of the inevitable consequences of the increasing dependence on interbank security, where a bank’s most saleable assets are pledged (with a haircut) to secure funding. As more of this happens, the risk to the unsecured depositors increases since the bank’s equity cushion becomes insufficient to protect them. Banks may think their cost of capital is reduced overall but this is because the taxpayers are not paid the risk premium their support for depositors requires. When Government finally explores ways to stop this, the system collapses.
The fix is simple. Stop banks borrowing from one another on secured terms. Immediately the traditional LIBOR market will be reestablished and quotes can reflect reality. But the ancillary benefits are even more important. With a negative pledge, the market would have to take over the regulators’ job (which they have performed so ineptly) of monitoring the credit health of counterparties: other banks will do this more efficiently. Resolution with pari passu treatment of all creditors will provide confidence that depositors in a reasonably well capitalised bank will not lose, while under the current system no sensible person can deposit money without security or a Government (implicit or explicit) guarantee. That is the unsustainable iceberg of which the LIBOR scandal is only the visible tip.
And you know what you have to do with eggs that float.