The Wheatley Report: A Libor Solution?

Each day seems to bring a fresh batch of troubling news about the global banking industry, doesn’t it? Last Monday, for instance, New York Attorney General Eric Schneiderman filed a lawsuit against JPMorgan Chase for deceptive practices involving mortgage backed securities loans. And later that same day, American Express agreed to pay a $112.5 million penalty for a wide array of deceptive and unethical practices.

On the other hand, most commentators have reacted favorably to the Wheatley Report, issued ten days ago by Martin Wheatley, managing director of Britain’s Financial Service Authority. Wheatley was asked to review the Libor system after a wave of devastating rate-fixing revelations led to a mammoth $450 million fine against Barclays and the forced resignation of its CEO.

The Wheatley Report recommends several critical modifications of the Libor system, enhancements that will undoubtedly protect the public interest. However, it also contains a trio of noteworthy provisions that may raise questions about whether Wheatley’s recommendations would fully restore confidence in the global banking system.

Government Oversight

Why has public reaction to the Report been so favorable? Generally speaking, it proposes a significant level of new government oversight over what has been a largely self-regulated system. Interestingly, the British Bankers Association (BBA) itself has welcomed these new proposals in light of its failure to prevent past manipulations of the Libor rates.

According to Wheatley, the process of collecting Libor quotations from individual banks should be taken away from the BBA and managed by the British government. Regulators should then subcontract the activity to a private sector organization, but should directly oversee its operations, conduct periodic reviews, and apply civil penalties and criminal sanctions to punish any wrongdoing.

All participating banks would be required to adhere to a Code of Conduct. They would also be required to appoint “Approved Persons” to manage the quotation submission process, and to submit to periodic audits by independent chartered accountants.

It is indeed difficult to find fault with any of these recommendations. Nevertheless, a trio of additional provisions in the Report may deserve critical scrutiny.

The Three Month Delay

The first noteworthy provision involves an unexpected proposal to abandon a longstanding practice of transparency. Namely, the Report suggests the imposition of a three month delay from the date of each individual bank’s rate submission to the date that it is revealed to the public.

Wheatley explains that this delay would prevent any bank from analyzing the recent quotations of its fellow banks to estimate how its own possible quotations would affect the Libor rates. In other words, he plans to force each bank to focus solely on its own internal data when developing its quotations, by denying it timely access to the contemporaneous quotations of its rivals.

Such a delay, regrettably, would deny the general public timely access to the quotation data as well. Journalists, academic researchers, and other guardians of the public interest would thus be unable to monitor the Libor system in “real time.”

Expansion and Compulsion

Another noteworthy provision involves the expansion of the roster of participant banks that submit rate quotations. Each participant, in the current small group, exerts a significant level of influence over the system itself. If participants are added to the Libor system, the influence of each bank would decrease in scope.

Thus, Wheatley recommends that British regulators be granted the authority to make participation compulsory for additional banks. In other words, he believes that the British government should be empowered to require banks to provide rate quotations to the Libor system, whether or not they wish to do so. But this proposal begs an important question: is this an appropriate application of government power?

An existential question can be posed, as well, about the fundamental nature of the Libor if it is transformed from a representative rate of the world’s largest banking institutions to one that incorporates a far larger number (and thus, inevitably, a broader array) of organizations. The current group is composed exclusively of banks that are considered relatively low risk institutions; would newly added banks, with smaller corporate footprints, change the very nature of the Libor group?

Transaction Data

The final noteworthy provision involves the definition of actual transaction data. Wheatley emphatically recommends that actual trade data provide support for all individual bank quotations.

But according to Box 4.B of page 28 of the Report, the Libor submission guidelines state that “in the absence of transaction data relating to a specific LIBOR benchmark, expert judgement should be used to determine a submission.” The guidelines also legitimize “techniques for interpolation or extrapolation from available data.”

What do these clauses mean? In short, according to Wheatley, the Libor participant banks will still remain able to rely on private judgement and estimation methodologies to determine their “actual” quotations. Such practices, of course, were what enabled Barclays (and, apparently, other banks as well) to manipulate the Libor rate in the first place.