The latest banking scandal on LIBOR (London Inter-Bank Offered Rate) rate fixing adds more fuel to the debate about ‘What to do?’ about banks and banking. Popular fury and renewed criticisms about banking culture and behaviour are inevitable. The stage is set for wider revelations involving other major banks, possible lawsuits and ever more restrictive regulation. Allegations have been made (and strenuously denied) of politicians ‘cosying up’ to the banks. In the meantime, the British press is having a field day in its continuing campaign against ‘banks and bankers’.
This latest scandal may become the ‘defining moment’ for banking when governments and regulators finally agree that concerted global and tougher actions are now needed to re-define what used to be the profession of banking. At a related level it also illustrates the potential dangers of the investment banking (so-called ‘casino’ banking) kind of culture that appeared to be a factor in this debacle.
Although Barclays is the present focus of attention (because it agreed to cooperate fully with regulators), many other big name banks are likely to be involved and may be exposed very soon. Investigations on the fixing LIBOR and other rates are currently under way in the US, Canada and the EU.
LIBOR is a benchmark rate that reflects the cost of borrowing for leading banks in London. The overnight LIBOR reflects the rate at which banks lend to each other – bank lending and many other important financial rates of interest across the globe are indexed to LIBOR. The Economist (July 7) estimates that around $800 trillion worth of financial instruments (from simple mortgages to interest-rate derivatives) are indexed to LIBOR. LIBOR influences the global flow of many billions of dollars every year.
LIBOR is set each day by a panel of 18 banks for ten currencies and for 15 maturities. The most important of these is the three-month dollar LIBOR. This is supposed to reflect what banks believe they would pay (on 11am on the day it is set) to borrow dollars for three months from other banks. Each of the 18 banks making up the Panel estimate what they believe they would pay to borrow. The top and bottom four estimates are disregarded, and LIBOR is estimated as the average of the remaining rates. The British Bankers Association ‘oversees’ this process.
LIBOR setting in this way is really a throwback to an age when banking cultures and objectives were different. Since LIBOR is based on banks’ estimates, it requires the rate-setting banks to play by the rules. Honesty and integrity are critical assumptions. But the recent scandal has revealed that ‘playing by the rules’ just did not happen.
What has been shocking is the apparent scale of the rate fixing that went on and the apparent ‘casual dishonesty’ of the banking staff involved. UK regulators – the FSA (Financial Services Authority) – tracked 257 messages in Barclays asking for LIBOR and other rates to be manipulated. Traders involved in manipulating the rate apparently joked and exchanged small favours. The Economist (July 7) reported that one trader promised another for a fiddled rate ‘Coffees will be coming your way’. Other such email traffic included expressions of thanks like ‘Dude, I owe you big time…. Come over one day after work and I’m opening a bottle of Bollinger’.
LIBOR rate fixing has revealed many practical issues that need to be addressed. A major issue is that it is based on banks’ estimates, rather than actual lending and borrowing prices. There is also a lack of transparency in the process, which makes dishonesty easier. Since there is an incentive to lie (banks may profit or lose money on the rate at which LIBOR is set), this lack of transparency facilitates it.
The scale of rate-fixing over two years by Barclays has been revealing of the present banking culture and an obvious embarrassment to a major British and global bank. The Barclay’s investigation has involved the FBI, a damning indictment in itself. Barclays was fined a record £60m ($93m) by the FSA (the biggest ever fine by a regulator). The Chief Executive and Chairman of Barclays have already resigned and a UK Parliamentary investigation is under way.
It is most unlikely that Barclays will be the only bank involved in rate fixing, whether of LIBOR or other benchmark rates. Up to 20 big banks have already been named. The global extent and impact of this latest scandal are potentially enormous. If it has distorted money markets in a way that affects anyone with a LIBOR-related contract, the potential legal claims could be enormous and far-reaching.
The first kind of LIBOR-fixing undertaken by Barclays was to help increase traders’ profits. The second kind (that started in 2007) was to help depress the bank’s LIBOR so that it appeared financially stronger (a high LIBOR was widely seen as a sign of weakness during the 2007-2009 financial crisis). It is alleged by Barclays that this was done with at least the tacit approval of the Bank of England. It might be argued that this motive for rate fixing did at least have a defensible aim, to help steady volatile and fragile financial markets in an attempt to lessen that scale and severity of potential system-wide risk escalating. Nevertheless, the Bank of England denies any collusion in this kind of rate fixing.
This latest scandal has stimulated a renewed debate about the pressing need to reform ‘root and branch’ the way that banking and finance are supposed to work. Renewed banking professionalism and a change in banking culture are demanded. Restoring trust and confidence in banking and those who run them must now be a top priority, but this will take time. The short-term response is likely to be greater transparency and stricter rules and regulations. In all of this there is always the danger of an excessive regulatory response, which may its own dangers.
In the meantime, the rate-fixing allegations and legal and other reprisals are mounting. The City of London’s reputation has inevitably taken a battering. Since banking and finance are one of the country’s most successful industries, the UK must take a strong lead in cleaning it up. There has to be a renewed emphasis on banking standards and a return to the concept that banking is a profession within an industry that enjoys many privileges, like indirect state support for systemically important financial institutions and lender of last resort support from the central bank. The recent crisis has also shown dramatically the key importance of banking and financial services to wider macro-economic health and stability.
2012 is London’s year on the global stage with the Diamond Jubilee and hosting the Olympics. The LIBOR rate-fixing revelations are not in keeping with this positioning and, indeed, much of banking and finance that does work well and professionally. The City of London and the UK must turn this latest bad news into the needed positive response that really starts to restore the trust and confidence that all stakeholders should have in their banks and financial system.