FT Alphaville " Libor, the liquidity consequences It's all very well bashing Bob and calling for bankers" heads. But we shouldn't overlook another exceedingly important point about the Libor affair, as picked up by Claire Jones over on the FT's Money Supply blog. Central banks, in many cases, target Libor explicitly. That is to say, monetary policy decisions are often moulded around attempts to influence the rate. Thus, if the rate is manipulated into being something it is not, there can theoretically be dire consequences for market liquidity. From the point of view of central banks the course of action is simple: the lower the Libor rate, the less liquidity the market needs. Thus the more Libor is under reported, the greater the misjudgment of liquidity needs by the central bank. The greater the undersupply of liquidity, meanwhile, the higher real Libor rate soars, the greater the attempts to manipulate it downwards. And so the vicious circle goes. Until eventually central bank actions become completely misaligned with reality, and Libor becomes impossible to hold back because the undersupply of liquidity in the markets is so pronounced. No wonder repo rates, which are conversely determined by real trades, became completely disconnected from these unsecured rates. Meanwhile, central banks that continue to use Libor rates in this formal fashion include the Swiss National Bank and the Bank of England, and to some degree the ECB (though, in their case it's Euribor). Thankfully, however, a debate is finally being had in central bank circles about the merits of targetting unsecured rates altogether - especially now that these rates have become completely vapourised and thus useless as indicators of liquidity needs. FT Alphaville hears the debate is even penetrating ECB circles. It's also worth noting, as Brooke Masters over on paper writes on Thursday, that the BBA - guardian of ye olde Libor rate - has finally come out of a state of denial and admitted it needs government help in supervising the process properly. As Masters writes: The BBA is currently reviewing the way Libor, which is the basis for $350tn in contracts world wide, is set amid probes that have swept in nearly 20 banks and a dozen regulators on three continents The trade body, which is co-operating with authorities in the investigation, is expected to issue a statement later on Thursday that will say: "The current Libor review in which our authorities are involved is considering all aspects including the setting process. A better course of action might indeed be switching over to an altogether new target, which is based on secured rates. In which case all of the above could be too little, too late from the BBA. Indeed, the market's attempts to establish a secured Ronia interbank market in the UK certainly imply Libor may very possibly beyond saving. Related links: Euribor has been vaporised - FT Alphaville A central bank is only as good as its target - FT Alphaville A target Treasury general collateral repo rate: Is a target repo rate a viable alternative to the target federal funds rate? - FRB For the love of Ronia (and repo) - FT Alphaville This entry was posted by Izabella Kaminska on Thursday, June 28th, 2012 at 13:37 and is filed under Uncategorised. Tagged with BBA, central banks, euribor, Libor, Monetary policy, monetary transmission mechanism, repo rates.