Process must be open, say Costas Lapavitsas and Alexis Stenfors
Royal Bank
of Scotland has been landed by US and UK regulators with a £390m finefor
manipulating the London interbank offered rate, hard on the heels of
fines forBarclays 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.
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.
39. LIBOR Games: Means, Opportunities and Incentives to Deceive, by Alexis Stenfors.
http://researchonmoneyandfinance.org/media/papers/RMF-39-Stenfors.pdf
40. LIBOR as a Keynesian Beauty Contest: A Process of Endogenous Deception, by Alexis Stenfors.
http://researchonmoneyandfinance.org/media/papers/RMF-40-Stenfors.pdf
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