What Did They Know, When Did They Know It? Part II (Revised)

Since the release of the commentary "What Did They Know, When Did They Know It and What Did They Do?: Part II," additional facts have come out concerning follow up actions by the Bank of England in the LIBOR fixing scandal and are now reflected in the revised version below.

Last Friday the Federal Reserve Bank of New York released 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, 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 FRB NY but one should reserve judgment for the time being. 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 presently 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 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.) Berkowitz’s research suggests that as few as four inaccurate submissions could bias the reported LIBOR rate. Others have shown that the rate could be manipulated, with even one biased submission.

The LIBOR-fixing 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. The whole 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. Such a system relies upon trust and honesty that can be challenged when market access and earnings pressures exist, and a trade group is not in a strong position to either police or correct the behavior of its members. The BBA bears a heavy responsibility for the current problems, which 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 LIBOR actually is.[1]

Fact number two is that regulators were aware of possible anomalies in the daily submissions. When they were brought to the attention of the British authorities, namely the Bank of England, as a result of a 2008 Wall Street Journal article, nothing of substance was done. Nor was there significant follow up 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. Indeed, the FRB NY documents also call into question the Bank of England’s Deputy Governor Paul Tucker’s claim that he was unaware of the problems until much later in 2009 since he was copied on the 2008 email exchange between Governor King and President Geithner that expressly stated that he had been instructed to look into the matter with the Manager of the Desk.

Fact number three is that staff members of the Markets Group at the FRB NY were clearly 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 as early as December of 2007 between staff of the Markets Group and Barclays’ staff 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 that other firms were also fudging the numbers. The tone of the transcript conversations raises a cultural concern. Both parties to the conversation seemed to view themselves as part of a closed club in which the exchange of information was freely given with little concern for confidentiality or the risk that such discussions might be viewed by outsiders 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 the Manager’s 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 the previous day, 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 might or might not have been recorded, about the efficacy of the LIBOR fixings, and whether any such concerns might have been transmitted to the FOMC.

The Markets Group is mainly a market monitoring and service group. It does not 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, although 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 is another matter and one that relates to the nature of the relationship between the Markets Group and the primary dealers with whom it transacts its daily open-market business.

The Primary Dealers are central to the transmission mechanism of monetary policy under the current structure, and there is a close relationship among those dealers, the Desk, and the Fed as demonstrated by the numerous emergency liquidity support mechanisms put in place to keep the dealers afloat during the financial crisis. There is clearly a symbiotic relationship between the Desk and the Primary Dealers, including Barclays – a relationship that one would not characterize as regulatory or supervisory. In fact, we noted in earlier writings that in 1992 the FRB NY 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 inappropriate. Subsequent events during the financial crisis, however, revealed that the subsidy and special position did indeed exist, but with an 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 past publicly available transcripts suggest that these presentations were at best tangential to monetary policy discussions or its formulation. Those transcripts suggest that LIBOR and 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. Given that that the Fed viewed the strains in financial markets during the period between the fall of 2007 and the fall of 2008 as mainly due to liquidity issues rather than solvency problems, concern would have been mainly focused on how information was or was not being processed by the market and whether reported rates might generate runs on the dealers, rather than concern about how the LIBOR was being fixed per se.

Again, there is room for more transparency on this point by the Fed. Also, it suggests that there may be an inherent regulatory conflict, both within the Fed and for British regulators, between concerns about market stability and the interests of investors and borrowers whose costs of funds and returns could have been significantly affected by misreported rates. Again, the available information suggests that institutional 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 for LIBOR-submitting institutions. (See Connan Snider and Thomas Youle, “Diagnosing the LIBOR: Strategic Manipulation and Member Portfolio Positions,” December 2009.

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 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 Governor King, would be especially enlightening.

Current FRB NY President Dudley could clearly enlighten us here, since he was the Manager of the Markets Group and Open Market Desk during the 2007-2008 period in question. 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, it is again relevant to know where the Barclays staff was located. If they were in the UK, then the problem was first a UK issue. If the staff was in Barclays NY office but the LIBOR data were reported from London, then the conversations were arguably second-hand accounts of what was being done in the UK, and this would 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 proceeds. For 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 has clearly done a poor job. Too many decisions and the financial interests of too many borrowers and lenders are at stake for the present system to continue as is. Second, we still don’t know much about what the US regulatory involvement was. As a side note, while the Fed may have lacked the authority to intervene or to police the LIBOR fixing, two things are clear. The Fed could have used its leverage on the Primary Dealer system to get more information on the LIBOR submissions, but didn’t.

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 Markets Group 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 as more facts become available.

[1] On the BBA LIBOR home page 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 …”