Other Issues the LIBOR Scandal Raises

One side of the LIBOR Barclays manipulation scandal brings up obvious questions related to fraud.  Barclay’s manipulation of interest rates for inside gain on long positions institutionally would seem to be textbook fraud.  Simon Johnson and Jennifer Taub provide good coverage on the level of overt manipulation and collusion involved and why this matters.  Unfortunately, on the legal side, the case for fraud here depends on the rules governing daily bank reporting to the British Bankers Association which sets LIBOR which are relatively tenuous. The Financial Services Authority (FSA) does prohibit breaching proper standards of market conduct and Barclay was fined of £59.5 million for doing so.  However, Barclay’s intentional misreporting is not covered under FSA’s market abuse criminal powers which must relate to investments that are trading on a market. So, the misreporting of financial data to the BBA, which isn’t a government entity or regulatory authority itself, is not explicitly governed by the FSA’s current legal authority.  A criminal investigation is now being pursued by the Serious Fraud Office, however, this is such a fundamentally important rate that there is a case for the imposition of a strong, explicit, legal reporting standard these banks must follow by law.  Additionally, the FSA should be given the means and authority to prosecute violation of intentional misreporting to the BBA. So more financial authority is needed for accountability to be robustly imposed. 

On the other hand, Barclays is being questioned from our side of the pond for their correspondence with the NY Fed in the run up to the crisis and after. Memos reveal heavy correspondence on LIBOR and bank lending rate reporting before and after the Lehman collapse. This begs entirely different questions regarding fraud, regulation and authority, and more, about monetary authority given the central role of LIBOR as an international benchmark on financial instruments.

In a perfect, monetarist’s world, there would be open market operations that the central bank can execute, sufficient to target short-term (and long-term interest rates) with a large degree of confidence. Since the Gold Standard was slowly abandoned, monetary policy has become more imprecise in the US. Liquidity created by banks and banking entities was concurrently left unsupervised. Thus, even in the US we have much less control over our key benchmark rate, the Federal Funds overnight rate, than many a central banker would like. But compared to London, we're in great shape. As revealed by this manipulation scandal, the benchmark for so many instruments in London (leaving aside so many internationally) is not controlled by operations by the Bank of England, but by interbank reporting on asset positions which affects liquidity and lending rates. 

But here’s the clincher, with the beginning of the structured finance market, the whole asset class was heavily contingent on one piece of architecture, which was executed through Structured Investment Vehicles or SIVs, which in turn were tied to LIBOR.  SIVs took the highest rated tranches of structured securities when no one else wanted to hold them. The question was, even then, why hold something that is rated the same as a Treasury by valuation pricing of risk, but which is surely not as tested in risk potential as a Treasury? Of course the answer to this was that there was some greater yield to be made holding those securities than Treasuries.  How this worked was by bright people seeing that LIBOR moved in concert with the interest rates on these AAA securities. So SIVs would borrow short-term money market instruments at LIBOR and buy up slightly undervalued AAA securities, while pocketing the yield. The only thing that mattered was that LIBOR was a lower rate than the rate on this tranche and that the correlation held up sufficiently, and the whole structured financial market was peachy keen. But we know that this did not happen and when Bear Stearns fell and interbank lending froze up here, it froze up in London and the relation between the rate on this asset class and LIBOR inversed suddenly with LIBOR skyrocketing. SIVs went bust or were brought on to banks’ balance sheets and the whole architecture behind ABS has largely been a sham ever since with the Fed largely coming in to inject the banks with capital while they were losing value on their SIVs and by taking over the underlying mortgage-backed securities market en masse.

Where I’m going next gives people at the NY Fed a lot of credit, but it’s safe to say that the relationship of LIBOR to the entire financial market in the US was very well understood by these people, especially after Bear seized credit markets and SIVs started going under. Unable to influence monetary policy and overnight lending here enough to change LIBOR would require greater measures to influence LIBOR. Would they call their banking counterparts in London to ask them what the hell was going on and to see if everything was looking clear? Yes, absolutely. Would we want them to? Yes, absolutely. Like I said, there was a lot riding on it, not simply the whole mortgage and asset backed securities market, but the entire financial system was at risk of another major credit revulsion. Did they make out handsomely? Not really, and I would even go as far as to say that wasn’t the point if we assume we’re dealing with a central bank’s banker during crisis here, who's just simply scared senseless everything is going to hit the fan on his watch.  And anyone who knows me personally knows I’d be the last person to defend something Tim Geithner does, but I would say, these dealings were front-end C.Y.A. maneuvers, rather than run-away collusion with friends (which I would typify TARP and financial regulation positionality out of Treasury as, under Geithner’s supervision). 

So, this points to the importance of international financial benchmarking and the need for international regulations to pre-empt lax regulations in various jurisdictions. Also, more regulation of reporting and all metrics used in risk assessments is needed, so we're not left with questionable practices that are technically fraudulent but not prosecutable.  

Robert Reich has raised the problematic role of bank-size in influencing markets with fraud, or not. A related concern is, frankly, how overgrown the finance sector is relative to the purchasing power of monetary authorities.  Am I arguing for more monetary power by central banks? Not in this pernicious environment, especially in the US, where there is a revolving door and “coincidences of interest” as well as direct conflicts of interest between the Fed and the financial sector.

I do recommend stringent international regulation of key benchmarks (including the limitation of creation of instruments using benchmarks that are not properly regulated or can’t be priced with large degrees of confidence). How did SIVs get to be so large and fundamental? They were part of the shadow banking system. So, this would entail all financial operations be out in the open and regulated at both the international and domestic levels.  I’m also proposing any and sundry mechanisms to stymie the overgrowth of the financial sector (and of the monopoly power of individual financial entities) that preclude prudential control over the entire financial system. This would include breaking up the banks, imposing a strong Volcker rule and a serious financial transactions tax. Dean Baker makes a good case for a financial transactions tax here. I would go further and support the position shared by his colleague, Bob Pollin, James Heintz and other economists who find the UK stamp duty tax rate of 0.5% on all stock trades, feasible and desirable for application in the US with the inclusion of smaller rates on bonds, options, forex transactions and derivatives.   

Beyond the domicile-level criminal aspect of the Barclays scandal related to fraud and collusion, these broader questions of regulation and anti-trust remain as important as ever to if we aim to manage systemic financial risk.