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February 6, 2013 6:45 pm
Royal Bank of Scotland has been landed by US and UK regulators with a £390m fine for manipulating the London interbank offered rate, hard on the heels of fines for Barclays and UBS. Several other banks will follow. The scandal appears to be one of the biggest in the history of finance.
Collusion among banks, and between banks and money market brokers, has been commonplace. The Barclays case revealed potential incentives to under or over-report Libor compared with the rate at which they actually lend to one another. First, because the daily payments on Libor-indexed derivatives portfolios depend on the level of Libor, manipulation allows banks to draw profits on them. Second, banks can avoid the stigma attached to signalling a relatively high funding cost. The UBS case showed that manipulation occurred on a vast and systematic scale.
This should be of little surprise. Bank manipulation of Libor is an outcome of the rate-setting process and has little to do with “bad culture”. Libor-fixing banks are profit maximisers that wish to look good compared with peers. The fixing process affords them the means and opportunities to achieve their aim by submitting deceptive rates. Incentives to deceive have become stronger because of the phenomenal growth of derivatives markets in recent years.
A congenial environment has been created for systematic collusion. The setting process facilitates, even promotes, manipulation because it resembles a Keynesian “beauty contest” – selecting not who you believe to be the most beautiful but who you believe others to find so. So banks make deceptively low Libor “bids” not because they necessarily intend to deceive directly but because they expect other banks to do the same. Since banks are not required to trade at the rate quoted, the result is that Libor systematically undershoots the true money market rate. The trimming process, where the highest and lowest quotes are omitted, is entirely inadequate as a safeguard.
Consequently, manipulation results in a wealth transfer across society in favour of banks. Equally serious is the impact on monetary policy. As long as Libor undershoots the actual money market rate, the central bank – where it uses Libor as a signal – is conducting policy on the wrong basis, with significant costs. It is reasonable to surmise, for instance, that central banks’ response to the 2008 liquidity crisis was too slow because the rates at which banks transacted were by 2007 probably substantially higher than Libor.
Authorities on both sides of the Atlantic have not fully recognised the systemic nature of the problem so their response is likely to be ineffectual. Regulators are striving to prevent individual or institutional wrongdoing when the problem is the fixing process. The Wheatley report, hastily prepared in September by the UK Financial Services Authority, and endorsed with equal haste by policy makers, is typical of this trend.
What is the London interbank offered rate and how did things go wrong?
First, it proposes practical reforms in the setting process. Libor will no longer be overseen by the British Bankers’ Association, the lobby group; individuals closely linked to the Libor-setting process will have to be authorised by the FSA; and the number of maturities and currencies for which Libor is used as a reference will be reduced drastically.
Beyond these minor changes, the report proposes two reforms relating to bank behaviour. First, frequent spot checks will be carried out to ensure Libor quotes are linked to rates actually used in transactions. Second, individual quotes by banks are to remain “secret” for three months to avoid the race to the bottom as a result of Libor stigma.
Is this enough to repair Libor? No. Banks will still not be required to trade at the submitted Libor quotes, and underbidding is likely to continue. Taking a small loss on an actual money market trade would make sense in order to profit from a large underlying derivatives position. Equally worrying is that the proposal to keep bids secret for three months will make Libor even less transparent.
What, then, can be done? Adam Smith observed that when traders meet in private, “the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. Libor-fixing is an institutionalised private meeting of banks that ends up serving their interests. The answer is public intervention in the rate-setting process, whether through the central bank or otherwise. That is the real policy solution.
Costas Lapavitsas is a professor at the School of Oriental and African Studies. Alexis Stenfors, a PhD student and former trader, received a five-year ban from the FSA for ‘mismarking’ at Merrill Lynch in 2009
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