The rotten heart of capitalism: interest rate-fixing scandals

The magnitude of the banking scam must be realised and tough action taken

The UBS building in Zurich. Photograph: Michael Buholzer/Reuters



This is the year the consensus changed. Around the world, policy-makers, regulators and bankers recognised that the legacy of the 20-year credit boom up to 2008 is more corrosive than all but a few realised at the time. The bankers – and the theorists who justified their actions – made a millennial mistake. Navigating a way out of the mess was never likely to be easy, but it is made harder still by not recognising the magnitude of the disaster and the necessary radicalism involved if things are to be put right.

If there were any last doubts they were dispelled by the record $1.5bn fine paid by the Swiss bank UBS for "pervasive" and "epic" efforts to manipulate the benchmark rate of interest – Libor – at which the world's great banks lend to each other. The manipulation was at the behest of the traders who buy and sell "interest rate derivatives", whose price varies with Libor, so that cumulatively billions of pounds of profits could be made. Nor was UBS alone. What is now evident is that all the banks that made the daily market in global interest rates in 10 major currencies were doing the same to varying degrees.

There was a complete disdain for the banks' customers, for the notion of custodianship of other people's money, that was industry wide. It is hard to believe this culture has evaporated with the imposition of a fine. No banker falsifying the actual interest rates at which he or she was borrowing or lending, or trader who requested that they did so, had any sense that there is something sacred about banking – that the many billions flowing through their hands are not their own. It was just anonymous Monopoly money that gave them the opportunity to become very rich. The UBS emails, which will be used to support criminal charges, could hardly be more revealing. This was about making money from money for vast personal gain.

Interest rate derivatives are presented as highly useful if complex financial instruments – essentially bets on future interest rate movements – that allow the banks' customers better to manage the risks of unexpected movements in interest rates. Whether a multinational or a large pension fund, you can buy or sell a derivative so you will not be embarrassed if suddenly interest rates jump or fall. Bookmakers lay off bets. Interest rate derivatives allow buyers to lay off the risk that their expectations of interest rate movements might be wrong.

What makes your head reel is the size of this global market. World GDP is around $70tn. The market in interest rate derivatives is worth $310tn. The idea that this has grown to such a scale because of the demands of the real economy better to manage risk is absurd. And on top it has a curious feature. None of the banks that constitute the market ever loses money. All their divisions that trade interest rate derivatives on their own account report huge profits running into billions. Where does that profit come from?

The answer is it comes largely from you and me. Global banking, intertwined with the global financial services and asset-management industry, has emerged as a tax on the world economy, generating much activity and lending that has not been needed, but whose purpose is to make those who work in it very rich. The centre-left thinktank IPPR reports that people with identical skills earn on average 20% more in financial services than in other industries, with the premium rising the higher the seniority. That wage premium does not come from virtuous hard work or enterprise. It comes from how finance is structured to deliver excessive profit.

Scandalous

The Libor scam is an object lesson in how finance taxes the rest of the economy. Plainly, the final buyers of the mispriced interest rate derivatives could not have been other banks, otherwise they would have lost money and we know that they all made profits. In any case, they were part of the scam. The final buyers of the mispriced derivatives were their customers. Some must have been large companies, but many were those – ranging from insurance companies and pension funds to hedge funds – who manage our savings on our behalf.

Here a second scam kicks in. One of the puzzles of modern finance is why the returns to those who buy shares in public stock markets are so much lower than the profits made by the companies themselves. One of the answers is that there are so many brokers, asset managers and intermediaries along the way all taking a cut. Sometimes it is through excessive management fees, but another way is not doing honest to God investing – choosing a good company to invest in and sticking with it – but through churning people's portfolios or unnecessarily buying interest rate derivatives to protect against interest rate risk, while charging a fee for the "service". Many of those mispriced interest rate derivatives will have ended up in the investment portfolios of large insurance companies and pension funds or, more sinisterly, in the portfolios of the banks' clients.

Most rotten

Bank managements are presented as ignorant dolts, fooled by rogue traders. They were no such thing. The interest rate derivative market is many times the scale than is warranted by genuine demand precisely because it represented such an effective way of looting the rest of us. The business model of modern finance – banks trading on their own account in rigged derivative markets, skimming investment funds and manipulating interbank lending, all to underlend to innovative enterprise while overlending on a stunning scale to private equity and property – is not the result of a mistake. It represents a series of choices made over 30 years in which finance has progressively resisted any sense it has a duty of custodianship to its clients or wider responsibilities to the economy. It was capitalism allegedly at its purest. We now understand it was capitalism at its most rotten. It needs wholesale reform.

The government's proposals to ringfence investment banking from the rest of a bank's activities, following the proposals from Sir John Vickers, is a start. But it is only that. Last week, Conservative MP Andrew Tyrie's cross-party parliamentary commission proposed " electrifying" the ringfence with the threat of full separation if malpractice continues. It also considered banning banks from trading in derivatives on their own account. But while tough, the commission should extend its brief. The issue is to create a financial system in its entirety that serves individuals and business alike, makes normal profits and, above all, embeds its public duty of custodianship in the bedrock of what it does. The government fears that more upheaval will unsettle banking and business confidence. It could not be more wrong. Reform is the platform on which a genuine economic recovery will be built.

Comment by Will Hutton - Guardian
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The Libor fuss!

The story behind the Libor scandal

Logos of 16 Banks Involved in Libor Scandal - YouTube

SINCE the outbreak of the Libor scandal, readers' reaction has ranged from the very basic: What's this Libor? to the more mundane: How does it affect me?

Some friends have raised more critical questions: Barclays appears to have manipulated Libor to lower it; isn't that good? The problem first arose in early 2008; why isn't it resolved by now? By popular demand to demystify this very everydayness at which banks fix this far-reaching key rate, today's column will be devoted to going behind the scandal starting from the very basics about the mechanics of fixing the rate, to what really happened (why Barclays paid the huge fines in settlement), to its impact and how to fix the problem.

What's Libor

The London Inter-Bank Offered Rate (Libor) was first conceived in the 1980s as a trusty yardstick to measure the cost (interest rate) of short-term funds which highly-rated banks borrow from one another. Each day at 11am in London, the setting process at the British Bankers' Association (BBA) gets moving, recording submissions by a select group of global banks (including three large US banks) estimates of the perceived rates they would pay to borrow unsecured in “reasonable market size” for various currencies and for different maturities.

Libor is then calculated using a “trimmed” average, excluding the highest and lowest 25% of the submissions. Within minutes, the benchmark rates flash on to thousands and thousands of traders' screens around the world, and ripple onto the prices of loans, derivatives contracts and other financial instruments worth many, many times the global GDP. Indeed, it has been estimated that the Libor-based financial market is worth US$800 trillion, affecting the prices that you and me and corporations around the world pay for loans or receive for their savings.

A file photo showing a pedestrian passing a Barclays bank branch in London. Barclays has been fined £290mil (US$450mil) by UK and US regulators for manipulating Libor. — EPA

Indeed, anyone with a credit card, mortgage or car loan, or fixed deposit should care about their rate being manipulated by the banks that set them. In the end, it is used as a benchmark to determine payments on the global flow of financial instruments. Unfortunately, it turns out to have been flawed, bearing in mind Libor is not an interest rate controlled or even regulated directly by the central bank. It is an average set by BBA, a private trade body.

In practice, for working purposes, Libor rates are set essentially for 10 currencies and for 15 maturities. The most important of these relates to the 3-month US dollar, i.e. what a bank would pay to borrow US dollar for 3 months from other banks. It is set by a panel of 18 banks with the top 4 and bottom 4 estimates being discarded. Libor is the simple average (arithmetic mean) of what is left. All submissions are disclosed, along with the day's Libor fix. Its European counterpart, Euro Interbank Offered Rate (Euribor), is similarly fixed in Brussels. However, Euribor banks are not asked (as in Libor) to provide estimates of what they think they could have to pay to borrow; merely estimates of what the borrowing rate between two “prime” banks should be. In practice, “prime” now refers to German banks. This simply means there is in the market a disconnect between the actual borrowing costs by banks across Europe and the benchmark. Today, Euribor is less than 1%, but Italian banks (say) have to pay 350-40 basis points above it. Around the world, there would similarly be Tibor (Tokyo Inter-Bank Offered Rate); Sibor and its related SOR (Swap-Offered Rate) in Singapore; Klibor in Kuala Lumpur; etc.

What's wrong with Libor?

Theoretically, if banks played by the rules, Libor will reflect what it's supposed to a reliable yardstick to measure what it cost banks to borrow from one another. The flaw is that, in practice, the system can be rigged. First, it is based on estimates, not actual prices at which banks have lent to or borrowed from one another. They are not transactions based, an omission that widens the scope for manipulation. Second, the bank's estimate is supposed to be ring-fenced from other parts of the bank. But unfortunately walls have “holes” often incentivised by vested-interest in profit making by the interest-rate derivatives trading arm of the business. The total market in such derivatives has been estimated at US$554 trillion in 2011. So, even small changes can imply big profits. Indeed, it has been reported that each basis point (0.01%) movement in Libor could reap a net profit of “a couple of million US dollar.”

The lack of transparency in the Libor setting mechanism has tended to exacerbate this urge to cheat. Since the scandal, damning evidence has emerged from probes by regulators in the UK and US, including whistle blowing by employees in a number of banks covering a past period of at least five years. More are likely to emerge from investigations in other nations, including Canada, Japan, EU and Switzerland. The probes cover some of the largest banks, including reportedly Citigroup, JP Morgan Chase, UBS, HSBC and Deutsche Bank.

Why Barclays?

Based on what was since disclosed, the Libor scandal has set the stage for lawsuits and demands for more effective regulation the world over. It has led to renewed banker bashing and dented the reputation of the city of London. Barclays, a 300-year old British bank, is in the spotlight simply because it is the first bank to co-operate fully with regulators. It's just the beginning a matter of time before others will be put on the dock. The disclosures and evidence appear damaging. They reveal unacceptable behaviour at Barclays. Two sorts of motivation are discernible.

First, there is manipulation of Libor to trap higher profits in trading. Its traders very brazenly pushed its own money market dealers to manipulate their submissions for fixing Libor, including colluding with counter-parties at other banks. Evidence point to cartel-like association with others to fiddle Libor, with the view to profiteering (or reduce losses) on their derivative exposures. The upshot is that the bank profited from this bad behaviour. Even Bob Diamond, the outgoing Barclays CEO, admitted this doctoring of Libor in favour of the bank's trading positions was “reprehensible.”

Second, there is the rigging of Libor by submitting “lowered” rates at the onset of the credit crunch in 2007 when the authorities were perceived to be keen to bolster confidence in banks (to avoid bailouts) and keep credit flowing; while “higher” (but more realistic) rates submission would be regarded as a sign of its own financial weakness. It would appear in this context as some have argued that a “public good” of sorts was involved. In times of systemic banking crisis, regulators do have a clear motive for wanting a lower Libor. The rationale behind this approach was categorically invalidated by the Bank of England. Like it or not, Barclays has since been fined £290mil (US$450mil) by UK and US regulators for manipulating Libor (£60mil fine by the UK Financial Services Authority is the highest ever imposed even after a 30% discount because it co-operated).

Efforts at reform

Be that as it may, Libor is something of an anachronism, a throwback to a time long past when trust was more important than contract. Concern over Libor goes way back to the early 2008 when reform of the way it is determined was first mooted. BBA's system is akin to an auction. After all, auctions are commonly used to find prices where none exist. It has many variants: from the “English” auction used to sell rare paintings to the on-line auction (as in e-Bay). In the end, every action aims to elicit committed price data from bidders.

As I see it, a more credible Libor fixing system would need four key changes: (i) use of actual lending rates; (ii) outlaw (penalise) false bidding bidders need to be committed to their price; (iii) encourage non-banks also to join in the process to avoid collusion and cartelisation; and (iv) intrusively monitor the process by an outside regulator to ensure tougher oversight.

However, there are many practical challenges to the realisation of a new and improved Libor. Millions of contracts that are Libor-linked may have to be rewritten. This will be difficult and a herculean exercise in the face of lawsuits and ongoing investigations. Critical to well-intentioned reform is the will to change. But with lawsuits and prosecutions gathering pace, the BBA and banking fraternity have little choice but to rework Libor now. As I understand it, because gathering real data can often pose real problems especially at times of financial stress, the most likely solution could be a hybrid. Here, banks would continue to submit estimated cost, but would be required to back them with as many actuals as feasible. To be transparent, they might need to be audited ex-post. Such blending could offer a practical way out.

Like it or not, the global banking industry possibly faces what the Economist has since dubbed as its “tobacco moment,” referring to litigation and settlement that cost the US tobacco industry more than US$200bil in 1988. Sure, actions representing a wide-range of plaintiffs have been launched. But, the legal machinery will grind slowly. Among the claimants are savers in bonds and other instruments linked to Libor (or its equivalent), especially those dealing directly with banks involved in setting the rate. The legal process will prove complicated, where proof of “harm” can get very involved. For the banks face asymmetric risk because they act most of the time as intermediaries those who have “lost” will sue, but banks will be unable to claim from others who “gained.” Much also depends on whether the regulator “press” them to pay compensation; or in the event legal settlements get so large as to require new bailouts (for those too big to fail), to protect them. What a mess.

What, then, are we to do?

Eighty years ago banker JP Morgan jr was reported to have remarked in the midst of the Great Depression: “Since we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgement and not of principle.” Indeed, bankers have since gone overboard and made some serious mistakes, from crimes against time honoured principles to downright fraud. Manipulating Libor is unacceptable. So much so bankers have since lost the public trust. It's about time to rebuild a robust but gentlemanly culture, based on the very best time-tested traditions of banking. They need to start right now.

WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: starbizweek@thestar.com.my.

Libor scandal blows to British banking system

The still-developing Libor scandal is the latest and biggest blow to the credibility of big banks and their regulators, and should catalyse wide-ranging reforms to the financial system.

THE reputation and credibility of banks, regulators and the banking system in Western developed countries, already battered by the twists and turns of the financial crises, have reached new lows with the Libor scandal, which is still evolving and will yet reveal more wrong-doing. Blow ... Barclays >>

Besides Barclays Bank, which has paid US$456bil (RM1.45 trillion) in penalties to the British and US authorities, at least another 11 banks that were part of the rigging of Libor face up to US$22bil (almost RM70bil) in penalties and damages to investors and counterparties, according to an article in The Financial Times.

This is likely to be an underestimate because in addition, they may also face fines of billions of dollars or euros from anti-cartel actions. And more than the 12 banks that are publicly named are involved.

The Libor scandal could not have come at a worse time because the banking sector is already mired in many deep crises.

That the biggest banks in the world have been manipulating the revered Libor rates, which the public for so many years considered something that is set objectively and scientifically, is almost unimaginable.

The manipulations were reportedly of two types: to influence Libor rates so that the bank could make profits in its derivatives trades, and to dishonestly portray that its own borrowing costs were lower than what they were, so as to raise the bank’s image.

The scandal hits at the heart of the global banking business, because Libor (the London Interbank Offered Rate), is the benchmark relied upon for many thousands of contracts in the financial world.

This new hit to the banks’ credibility comes at a time when there are new signs of a serious downturn in the global economy.

In particular, the growth rates of many major developing countries have declined significantly in the last three months, signifying that the banking and debt crises in Europe are beginning to have a serious impact on the developing world.

The Libor scandal may contribute to the deteriorating world economic situation.

At the least, the banks involved in the scandal may have a worsened financial position, with less credit to provide to the real economy.

The estimated fines would cut 0.5% off their book value, and each bank may also have to pay an average of US$400mil (RM1.27bil) because of lawsuits, according to a study by Stanley Morgan, as reported in The Financial Times.

This may only be the tip of the iceberg. Regulators in many countries, other than Britain and the United States, are investigating, including Canada, Japan, and Switzerland, while many corporations and lawyers are considering lawsuits against the banks. The credibility of the European and US regulators have also been affected.

Either they did not know about the manipulations of the banks and were thus not doing their job, or they knew about it and allowed the deception to continue for years.

Manipulation in the Libor system was apparently known, at least in the trade, by 2005.

In April 2008, an article in Wall Street Journal raised questions about the way Libor was set.

Last week (on July 13), documents released by the New York Federal Reserve showed that US officials had evidence from April 2008 that Barclays was knowingly posting false reports about the rate at which it could borrow, according to several news reports, including in the Wall Street Journal.

A Barclays employee told a New York Fed analyst on April 11, 2008: “So we know that we’re not posting, um, an honest Libor.”

He said Barclays started under-reporting Libor because graphs showing the relatively high rates at which the bank had to borrow attracted “unwanted attention” and the “share price went down”.

The Fed analyst’s information and concerns were passed on to Tim Geithner, then head of the New York Fed.

In June 2008, Geithner sent a memo to the Governor of the Bank of England, with six proposals to ensure the integrity of Libor, including a call to “eliminate incentive to misreport” by banks.

The documents show that the US authorities knew about irregularities in the Libor interest-rate market and had discussed the need for reforms with the British authorities as far back as mid-2008.

The question being asked is why the regulators did not act until this year.

The Libor scandal may be, or should be, the final straw that forces the developed countries’ political leaders and financial authorities to undertake a thorough and systemic reform.

The financial system has been plagued by one crisis and scandal after another, and of crisis responses.

There needs to be reform of the regulatory framework and enforcement, the hugely excessive leveraging allowed by financial institutions, the laws that permit a combination of commercial banking and proprietary trading in the same institution, the speculative and manipulative activities and instruments of financial institutions, fraudulent practices and the incentive system, including unjustified high pay and bonuses and high rewards to bankers for speculation-based earnings.

A reform of the Libor system or establishing an alternative to it is of course also required.

In the Libor system, a panel of banks will set the borrowing rates for 10 currencies at 15 different maturity periods.

Two types of manipulation emerged in the Barclays case.

The first involved derivatives traders at Barclays and several banks trying to influence the final Libor rate to increase profits (or reduce losses) on their derivative exposures.

The second manipulation involved submissions by Barclays and other banks of estimates of their borrowing costs which were lower than what was actually the case.

Almost all the banks in the Libor panels were submitting rates that may have been 30-40 basis points too low on average, according to The Economist.

GLOBAL TRENDS By MARTIN KHOR newsdesk@thestar.com.my

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