In order to work well, markets need a basic level of trust. As Alan Greenspan said, in 1999, "In virtually all transactions we rely on the word of those with whom we do business." So what happens to a market in which the most fundamental assumptions turn out to be lies? That is the question in a scandal that has roiled the banking industry all summer. The LIBOR (London Inter-bank Offered Rate) index is the most important set of numbers in the global financial system. Used as a benchmark for interest rates around the world, it's assembled by asking a panel of big banks to estimate what it would cost them to borrow money today, if they had to. Hundreds of trillions of dollars in derivatives, corporate loans, and mortgages are pegged to these rates. Yet we now know that for years LIBOR rates were rigged. Barclays has agreed to pay nearly half a billion dollars to regulators for its manipulations, and a host of other big banks are under investigation for similar misdeeds.
Rigging LIBOR was shockingly easy. The estimates aren't audited. They're not compared with market prices. And LIBOR is put together by a trade group, without any real supervision from government regulators. In other words, manipulating LIBOR didn't require any complicated financial hoodoo. The banks just had to tell some simple lies.
They had plenty of reasons to do so. At Barclays, for instance, traders were making big bets on derivatives whose value depended on LIBOR; changing rates by even a tiny bit could be exceptionally lucrative. In the years leading up to the financial crisis, these manipulations were, in the words of the Commodity Futures Trading Commission, "common and pervasive." And, once the crisis hit, banks had a new incentive to distort LIBOR: if their estimates were higher than their peers' (meaning that it would be expensive for them to borrow money), investors, creditors, and regulators would worry that they were about to go under. So the banks sent LIBOR downward in order to make themselves look stronger than they were. The result was that, instead of reflecting what was real, LIBOR reflected what the banks wanted us to believe was real.
David Fuller's view Governance is everything, as we often say at Fullermoney, and it has been a long time since self-regulation worked in the financial industry. However, what we need is strong, intelligent and simplified regulation, not layers of stifling, bureaucratic and expensive compliance. Good regulation starts with an emphasis on ethical standards and laying down common sense rules in terms of what is acceptable. That way malfeasance can be identified, understood and punished, from the top down.
It has been said that the rigging of LIBOR was so pervasive that senior management within many more banks could and would have been sacked, were it not for concern over the industries' ability to function following such a sweeping clearout in one go.