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Libor Rigging Predictable, Inevitable

We'll know we've hit dead bottom when there's no more surprise or shock. So, reactions to Libor revelations show we're nowhere near bottom yet.

The Libor scandal is unsurprising, in fact inevitable, resulting from four powerful causes: London, self-regulation, control by big banks and dream world "data." Let's defang all four of them.

First, London. According to Bloomberg News, banks have formed 10,000 subsidiaries in order to benefit, among other things, from laxer regulation. London is the preferred destination if you want less regulation. That's most likely why JPMorgan Chase's chief investment office is in London. Competition in regulatory laxity is another manifestation of the accelerating race to the bottom. 

Let's subject everything owned or controlled by a U.S. bank or bank holding company, worldwide, to the full rigor of U.S. regulation — at the bank's expense. It beggars imagination to hear Treasury Secretary Timothy Geithner say that merely reporting Barclays to the Bank of England was enough.

Don't rely on foreign regulators. If you allowed a U.S. bank to have a Spanish subsidiary that was regulated by the Spanish and performed like a Spanish bank, it wouldn't survive. Ditto for a German subsidiary that German regulators encouraged to load up on Greek bonds. 

Every U.S.-based entity's entire worldwide network should meet all U.S. requirements — as well as those of any foreign hosts.

A second reason Libor self-destructed is self-regulation — which has been a Swiss cheese of ineffectiveness since the '30s.  That's what gave us the National Futures Association, supposedly policing Peregrine and 55,000 industry employees. How about the International Swaps and Derivatives Association? A "default" (like the Libor rate) is defined by polling of the heavy hitters — 80% required! — not by facts. Then, there is the British Bankers' Association, toothless guardian of Libor. 

There's a better alternative. If we freed the CFTC from the congressional appropriations process, as we've done for the CFPB, then the CFTC could make the industry pay for its own regulation, which is only fair — and the agency could afford to regulate effectively without relying on subordinate self-regulators. Same for the SEC. Otherwise, blame Congress and ultimately the voters for preventing effective regulation by refusing to appropriate the necessary funds.

Self-regulatory organizations vindicate the interests of the regulated, not the public interest. How could the BBA be an exception? 

Third, if big banks collectively provide all the inputs determining Libor, without independent verification or appeal, then these banks will collectively set Libor for their own best advantage. Does it take an MBA to figure that out? Or maybe a Ph.D. in statistics tuned to top and bottom 25 percentiles? A law degree?

Finally, and most important, the inputs from banks that entirely determine Libor aren't even supposed to be facts. They are nebulous fantasies, hopes or, if you're a Pollyanna, guesswork. We're pricing many trillions of dollars of real transactions on the basis of a few imagined transactions. A practice so obviously idiotic persists only because banks benefit from and impose it.

So the big banks control Libor absolutely — through supinely regulated London; through the BBA, their alter ego; through providing all the inputs and through the elastic, virtual-reality input definitions that give them so much latitude to optimize. 

Banks trade or originate most of the contracts indexed to Libor. So it's not surprising that they've managed to impose this scarcely regulated and largely irrelevant Libor standard on their scattered nonbank counterparties. 

Suppose for a moment you're a small counterparty, let's say a U.S. municipal treasurer, whom a fast-talking saleslady has persuaded to buy an interest rate swap you didn't need. She tells you the variable rate will be Libor plus 1.85%. You look at the Libor rate today, and its historical graph. You can take it or leave it. 

Subsequently, of course, the banks will put their green thumbs or an elephant on the scale, perverting the rate.

Is that OK?

No, it's terrible. A party paying to get a rate that tracks real, market funds value instead has a rate that's dominated by noise and self-interest — faked in order to disadvantage nonbank counterparties. A rate that falls into a blacker limbo of meaninglessness in crises, when banks aren't lending to each other.

The solution, obviously, is to index contracts to a market rate reflecting real transactions. Even in a crisis, there are T-bill rates and the equivalent for other currencies. Those are market rates. The markets are extremely liquid.  Or use average deposit rates which, again, are real rates. Contracts could specify that in the event of a severe crisis, if there really are no market rates available, central bank lending rates such as the Fed discount rate or federal funds can be used as a backup.

Counterparties and the government shrug. As they have for decades. But today's amazement and stupefaction are strange reactions to familiar bank behavior driven by obvious financial self-interest. Now we'll further enrich lawyers with litigation punishing bank shareholders.

We have to lay off the megabanks? Because we need them? To do what?

Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.


(4) Comments



Comments (4)
It would be nice if the "public" and its pundits would step back for a moment and take a deep breath. A bank chartered in the US and insured by the FDIC must operate in full compliance with US standards everywhere it does business, even in any foreign operations it may have. And what is the difference in US and UK regulation of base interest rates? US banks set their prime rates at whatever level the market will bear. They adjust them up if they want to slow loan volumes and reduce their prime rate if they want to increase loans. No regulator dictates how the prime rates are set. It is one of those unspoken rules that the prime rates follow the Fed to a degree but it is not compulsory.
Posted by gsutton | Monday, August 06 2012 at 8:19PM ET
The industry has lost the confidence of the public.

It's time to step up to the plate, take responsibility and at least attempt to act like responsible adults. Until then, the industry will find more deposits buried in the backyards of consumers than they'll find in their ATM's.
Posted by JeffreyLAllenBroker@gma | Monday, August 06 2012 at 3:49PM ET
How about we regulate and examine the big financial institutions with the same rigor that the small banks get. Our bank is highly rated, and at our last exam there were more examiners present some days than we had employees. What would happen if 300,000 examiners showed up at one of the large banks? It only seems fair.
Posted by dahlers | Monday, August 06 2012 at 3:09PM ET
Couldn't agree more! Finally a voice that is contrary to the group think that we ususally get from finanical publications and prognosticators who sound like paid spokespersons for the banks. Self regulation is an oxymoron, and those who think not are simply oxymorons sans 'oxy'.
Posted by BankthinkReader | Monday, August 06 2012 at 1:14PM ET
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