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Friday, October 5, 2012

The Dark Side of Risk Management

Risk management can be a paradox in nature and this often leads entire communities, perhaps society at large to entertain red herring solutions for systemic threats. 

Today I can see at least three man made ills which may be killing us broadly and as a global community they are. Long term side effects may take us to a place that is far worse than where we are at present. Perhaps we should carefully rethink what we are trying to achieve because we may just find our desperate first attempt to resolve the unwanted is often not the most ideal solution.

Shutting down Libor, disbanding nuclear power and embracing a never ending program of Quantitative Easing could have dangerous outcomes which are not really understood in the long term. Let's take a look at Quantitative Easing and Libor, we can talk about nuclear power another time.

Quantitative Easing
Quantitative Easing and austerity programs together in a global economy probably will not bring a "Glocal" economy away from the deathly grips of a recession. Certainly, one single shot of QE is never going to be enough it seems but either way these economic tools can induce several unwanted side effects.
A central bank implements quantitative easing by buying assets from the financial sector with newly created money, it is a method of injecting cash directly into the economy in the short term.
Central Banks often increase the excess reserves in banks by raising the prices of assets and lowering their yield, this should be seen as a last ditch effort to enter into an expansionary monetary policy. Normally the QE bullet is used when interest rates are already on the floor and can't be lowered further, however quantitative easing has a tendency to drive unwanted inflation, it suppresses long term yields and this can have impacts on many aspects of the economy. One such disorder is the benchmark of performance or the outlook pension funds have to endure, another issue might be that QE actually doesn't stimulate the core economic growth it is designed for.

We know from looking at history and in old strategies from the Bank of Japan that Quantitative Easing has not often resulted in the long term desired effects for which it was designed. Today however, we seem bent on giving the idea a twirl again. For the record, we are now moving into yet another attempt to do this with QE3 and the results are quite exciting for the equities market but is there any real GDP growth under this?

The proverbial question is; how much effect is Quantitative Easing having on the ISM index for example. As positive as it may appear on the surface, has the economy become "addicted" to this perpetual cash injection. Perhaps we should ask ourselves a different question? ... If we put an end to the QE buffer, would the economy collapse back into a recession, would it move from one jurisdiction to another?

What a lot of people seem to forget is that QE3 is actually another solvent in a long desperate line of like actions to save the economy or more so the banking sector and to date, the number of bailout programs executed by the Federal Reserve alone is really quite staggering.

Federal Reserve Emergency Actions | FED Congressional Address [ Click image to enlarge ]
Many people are also not aware that 65% of the TAF loan support programs were actually taken up by foreign banks with branches or subsidiaries in the United States, rather than local onshore institutions.

Banks accessing Emergency Funding FED Congressional Address [ Click to enlarge ]

Nevertheless, the Federal Reserve has released a document that goes under the title of "The Forward Guidance Puzzle". This publication attempts to describe forward guidance or as the document puts it: 
With short term interest rates at the zero lower bound, forward guidance has become a key tool for central banks and yet we know little about its effectiveness. The authors of the Forward Guidance Puzzle are apparently working with laboratory economies to study the impact of policy experiments never performed before. 
That is what they state, as worrying as that comment is.
Carlstrom and Smets predict explosive inflation and output, if the short-term interest rates were pegged at the zero level base between eight and nine quarters.  This is an unsettling finding, given that the current horizon of forward guidance by the FOMC is of at least eight quarters.
This paper is very interesting and well researched but while it highlights that there could be some ill effects from Quantitative Easing which need some additional consideration, it doesn't seem to treat them.

The lie in Libor
In regards to the lie in Libor, this is an entirely different issue but it is a systemic quandary nonetheless and here yet again, we are potentially misreading the underlying flaw of the system and consequently mistreating the systemic condition within this man made ill.

Libor manipulation isn't new and while the whole debate has been a public affair for months, the rigging of Libor goes back a lot further than this, years to be precise and academics have been critiquing the controversy of Libor since its inception. What amazes me is why any of this should come as such a great surprise to the world but apparently it does. What this does tell us is that just about everyone who isn't tangled up in Libor seriously misunderstands it.

So let's clear up a few perplexities of Libor.

[1] Rigging Libor in the grand scheme of it all does not benefit the rigging bank. Banks are generally lending long and borrowing short, they are in the business of selling buckets of interest rates, just as refineries move barrels of oil.  So if that is the case then, those that fix in the wholesale market are going to be burned on the street facing desk and the same applies in reverse. Let's be real for a moment, rigging in this case is a zero sum game overall and you can think of it like a seesaw problem without any horizontal movement.

But there is more to this ...

[2] In the way Libor works, true rigging would only be meaningful or potentially profitable if the entire industry collaborated on the rig. A single bank quoting a rate outside the accepted prevailing rate band was normally cut out of the benchmark by the British Bankers Association and consequently rigging really had quite a limited and narrow scope.

So to seriously rig requires more than one player. Yet to date the only bank that has specifically been hung out to dry from the regulators on Libor manipulation is Barclays. Bob Diamond's preemptive move to fess up to the regulators was perhaps a fatal tactic or premature plan. From his perspective he wasn't even the CEO at helm of Barclays when street facing traders crossed the internal Chinese walls to fiddle rates.

Barclays is being accused of two crimes, one an internal fiddle that costs the bank and profits the trader, the other was an industry wide rig.

Credit Crisis Impact on the interbank Market | Bloomberg 

Libor is and has always been an opinion board for prevailing interbank offering rates. Importantly, the Lie in Libor is an ideal gauge for interpreting prevailing credit and liquidity funding issues financial institutions have between themselves. It is also possible that if banks hadn't collaborated on Libor rates during the credit crisis, the entire system might have actually gone into meltdown.

The Wheatley review clears up a lot of confusion in Libor and it is a pretty good summation of what happened [ Link ]. However, if you read the message that is encapsulated in the text, we have to accept some of the following:

[1] Whatever improvements are made to LIBOR, it is unlikely that markets will want to consider alternative benchmarks that fail to show the Lie in Libor (the credit and liquidity funding quality). 
[2] Given the global importance of LIBOR, a decision to migrate towards alternative benchmarks should be coordinated at an international level by relevant bodies.
[3] The issues that have been identified with LIBOR, have broader implications for a range of other benchmarks which operate in the same way, even including weather reporting.
[4] It may not be possible to correct the problems in LIBOR and maintain the purpose for which LIBOR was designed.

More importantly, where do we go as a community to correct Libor?

If the "Salem Witch Hunt" for Libor fibbers continues, perhaps a broader industry consultation is required but as it stands, regulators are determined to scavenge every corner of the earth for Libor riggers.  The worse place we could possibly imagine would be to shut down Libor because there is a purpose for this beast of an index and, while the measure is only gauge on forward rates, it is entangled up in a lot of what we value in the financial markets.

The final recommendations from Wheatley are:

  • Introducing a new regulatory structure for Libor, including criminal sanctions for those who attempt to manipulate it.
  • Inviting other groups to apply for taking over the BBA's role, which will also include drawing up a code of conduct and carrying out regular audits.
  • Encouraging banks not part of the current group of 20 rate-setters to submit rates to Libor to make it more representative.
  • Basing Libor calculations on actual rates being used, rather than estimates currently provided by banks.
  • Cutting the number of Libor daily fixings from 150 to just 20 and reducing the number of currencies looked at to better reflect the most-used rates.

Libor Interest Rates | BBC News

All good, yes? ... NO!

Cutting the number of Libor daily fixings from 150 to 20 and reducing the number of currencies quoted, is a disaster in the waiting. It is a fudge not a correction of the problem and it makes the index innocuous. In fact, it is going to push rate setting to a deeper underground place than before Libor existed and for which Libor was created for and resolved in part. In effect, we have solved the problem by using a maximum absolute. Here is a different way of thinking about it; let's say we wanted to cure the world of Malaria, one simple way is to slaughter all the people. If there aren't any people, there isn't a Malaria problem because there aren't any reported statistics of the ailment.

So what are we saying here?

Transactions under Libor | The Wheatley Review

In the short of it, where there is a low traded activity in Libor, quoting is going to be scrapped. This isn't so good for some people and an arbitrage opportunity for others but while banks don't often trade in this zone, the street facing customers do.

So to sum it all up, I believe the Wheatley review is a great research paper but the recommendations are not a solution to the Libor fixing problem. What we are going to see is a lot of unwanted knock-on effects and systemic disorders from this potential ruling, just as we are going to experience in the long term side effects from Quantitative Easing.

1 comment:

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