Friday, May 30, 2008

Waiting for the BBA LIBOR verdict

(FT Alphaville) We know you’re all on tenterhooks. But it sounds like the BBA statement/report/musings on Libor is unlikely to be available until the latter part of the afternoon, after the committee has met. We’re told that the meeting kicks off at 1.30pm.

The WSJ on Thursday cast further aspersions on the validity of the interbank benchmark with their study, which drew criticism from Alea and Felix Salmon.

But the consensus seems to be that Friday’s output from the BBA will be undramatic, likely to raise issues, table ideas and leave to ferment. For a start, as the FT points out, the fragile state of interbank lending means that now may not be the time for an upheaval in calculating the widely-used benchmark.

1342.jpgIn the meantime, Morgan Stanley’s team adds their take:

Criticisms of LIBOR that it is unrepresentative have some strength: certainly, it is true that the term interbank lending market barely trades. But although on the face of it this is a damning flaw, it actually isn’t. Crucially, the LIBOR fixings are so well-correlated with other money market lending rates that LIBOR continues to fulfil its chief function as a reference index (see Exhibit 1).

[Thursday]’s critique in the WSJ is interesting, but it falls down by trying to combine generic term lending rates with the cost of idiosyncratic default protection. By doing so, it paradoxically reinforces the value of the LIBOR fixing process in producing a generic reference rate, even during stressed periods when bank risk is more heterogeneous than usual.

Of the potential changes that could be made to the LIBOR fixing process, perhaps the most interesting would be to initiate a system similar to that in the AUD and NZD money markets, where the fixings are preceded by a brief period of trading of bank bills. This could improve the transparency and credibility of the fixings to some degree; we would applaud its introduction.

Other possible changes include: changing the timing of the USD fixing; increasing the number of US-domiciled banks in the USD fixing; expanding the number of reporting banks; and preserving the anonymity of contributing banks.

We expect none of these potential changes to alter the level at which LIBOR fixes to any great extent, because LIBOR is already a good reflection of money-market lending rates. If the LIBOR methodology were to be replaced, it would be by something that would give almost exactly similar results, in our view.

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