James Saft, Reuters Columnist
Understanding why puts us a bit closer to reckoning with exactly how false and officially supported financing markets are, a realisation which manages to be both terrifying and strangely reassuring.
Interbank lending, the lifeblood of financing, is, where it is functioning, increasingly based on doubtful or illiquid collateral swapped among banks which are often acceptable only because they have government backing and access to central bank funding. This is particularly true in the euro area, where the European Central Bank seems to go ever further to support bank liquidity.
Against this background, the proposed reforms of the London Interbank Offered Rate (Libor) take on a kind of bitter irony, even necessary and well-intentioned as they are.
Reuters parent company Thomson Reuters Corp collects information from banks and uses it to calculate Libor rates according to specifications drawn up by lobby group the British Bankers Association, which will no longer be involved.
Britain’s Financial Services Authority will try to salvage Libor, which has been deeply damaged by a rate-fixing scandal, taking responsibility for direct oversight, widening the number of banks which participate and making manipulation of the rate for financial gain a criminal offence.
This is really the definition of a false market, one held together and dictated largely by fiat from on high, rather than real price discovery at ground level.
Libor was manipulated in at least two ways: kept too low by banks which lied about the rate at which they could borrow in order to appear more sound; and jigged this way and that by a couple of basis points by traders seeking to profit privately.
Euribor-EBF, which sets the euro zone version of Libor, is considering similar reforms, but is exploring using actual borrowing rates, rather than a bank’s own estimates of its cost of funding.
The reforms are all well and good, but like most lies, the London Interbank Offered Rate required assistance from all sides – banks, investors and regulators.
Credit, or the lack of it, is a vicious or virtual cycle, depending on your outlook. In pre-crisis days banks raised funds freely and cheaply in the interbank market. The realisation that some banks might be, or shortly become, bust froze that market, requiring government and central bank backing and intervention.
Collateral scarcity
Nowhere has this intervention been more stark than in the euro zone, where the ECB has taken on increasing amounts of both banking and sovereign risk in its efforts to make up for the failures of secularisation and the interbank market.
Now it has always been true that in a system with banking insurance and fiat money, one where the government creates money without holding collateral, banks ultimately are creatures of government, only able to exist with government backing, and subject to rates of borrowing which are dominated by government policy.
The ECB has gone further and further to support its banks, and in a circular way, their weakened sovereign backers, accepting a wider array of collateral, pledges against promises, doing funding for unlimited amounts and longer periods and now even taking collateral in foreign currencies.
Despite all of this, the amount of “good” collateral available in the system has been in short supply, as lenders increasingly insist on higher-quality pledges and as more of it ends up parked with the ECB in exchange for cash.
“There is a difference between scarcity and shortage. Scarcity is a fact and not a problem per se. Allocating scarce resources through prices is the way our economies work. The problem would be a shortage of collateral and/or an impaired price mechanism,” Benoît Cœuré, member of the Executive Board of the ECB, said in a speech on Monday.
He argues that this is not the case, but the facts tend to argue back. There has been a huge growth in non-marketable securities – mostly bank loans – pledged to the ECB in recent years. The other huge growth area of collateral pledged to the ECB has been covered bank bonds, a type of over-collateralized bond accepted by the central bank as part of its long-term refinancings.
This is really the definition of a false market, one held together and dictated largely by fiat from on high, rather than real price discovery at ground level. Libor too, though it may be on a tighter leash, will still at a very real level be dependent and determined by government and still set against a backdrop of manipulation.
That might be better policy, but it is still not a real market.