Satyjit Das: The LIBOR Fix – Part II

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk and Traders Guns and Money. Jointly posted with roubini.com

The scandal surrounding the manipulation of LIBOR sets raises a number of issues. The first part of this two part piece set out the known facts. In the second part, the broader implications of the episode are discussed.

The Long Fix …

Lord Turner, the head of UK FSA, told a UK parliamentary Committee that it hadn’t occurred to him before 2009 that the rate was something that could be manipulated. However, anecdotal evidence suggests that LIBOR submissions may have been manipulated over a long period. Banks and regulators may have been aware of these practices for some time but did not take corrective action.

Barclays’ senior management and board of directors have indicated that became aware of the problem recently. Banks offer the same excuse as JP Morgan Junior in 1933: “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 judgment and not of principle.”

The practice appears blatant and warnings were ignored. Canadian court documents indicate that a UBS employee contacted employees at other banks with a view to achieving a “certain movement” in Yen LIBOR. The correspondence does not attempt to hide the actions from superiors or express concern about any breach of internal or regulatory rules.

In a Singapore lawsuit against RBS for wrongful dismissal, a trader Tan Chi Min alleged that he and colleagues were regularly consulted by senior managers and personnel responsible for setting the bank’s Yen LIBOR. The filing alleges that there was no regulation, policy or guidelines for submissions. RBS’s position is that Tan was dismissed for trying to manipulate the bank’s rate setting to benefit his trading positions between 2007 and 2011.

Between 2007 and 2008, it appears that Barclays’ compliance department did not act on three separate internal warnings about conflicts of interest and “patently false” rate submissions. In an opinion piece published in UK’s Independent on 7 July 2012, a former Barclays’ employee alleged that problems with LIBOR fixings were escalated by several people up to their directors and further within the organisation.

Recent disclosures indicate that UK and US regulators knew that banks were posting artificial rates which did not correspond to the actual rates that the banks would pay to borrow. In April 2008, a Barclays’ employee notified the Federal Reserve Bank of New York (“New York Fed”) that the bank was underestimating its borrowing costs. A transcript of the telephone call is revealing: “….we know that we’re not posting um, an honest LIBOR … we are doing it because um, if we didn’t do it … it draws, um, unwanted attention on ourselves.”

On 1 June 2008, Timothy Geithner, then head of the New York Fed, emailed Mervyn King, Governor of the BoE, urging changes in the way the LIBOR is calculated. Internal New York Fed reports reveal concern about possible misreporting of LIBOR. None of these concerns were made public or steps taken to address the problem. Regulators, it seems, feared that the truth would destabilise already panicked markets.

TBTF to TBTJ…

Large banks are too big too fail (TBTF), a concept now codified in bank regulations. It remains to be seen whether large banks and their employees are too big to jail (TBTJ).

Authorities have settled cases of LIBOR manipulation, perhaps driven by a desire to avoid creating a banking panic in an environment where financial institutions are vulnerable.

Barclays received immunity from prosecution in return for co-operating and settling the matter. UBS too has received limited immunity from Canadian and Swiss regulators in return for co-operation.

The UK FSA case was based on breaches of various parts of its Principles for Businesses code, specifically Principle 5 which requires a firm must observe proper standards of market conduct. The report concluded: “The definitions of LIBOR and EURIBOR require submissions from contributing banks based on their subjective judgement of borrowing or lending in the interbank market. The definitions do not allow for consideration of derivatives traders’ positions or of concerns over the negative media perception of high LIBOR submissions.” The US Department of Justice (“DoJ”) cited violations and misconducts, without specifying offences.

The actions prima facie constitute manipulation and fraud, violating applicable securities laws. It may also breach anti-trust and criminal law. Evidence released shows possible criminal intent. Emails indicate awareness of the illegality: “don’t talk about it too much”; “don’t make any noise about it please”; “this can backfire against us”. Individual traders and the bank which is responsible for its employees’ actions would be liable.

Facing media attention and public fury, US and UK authorities are belatedly exploring possible criminal charges.

Big Fix…

Responsibilities for oversight of the LIBOR setting process are unclear.

Barclays has criticised the BBA: “During this period, Barclays was consistently raising concerns with the BBA, questioning why other banks’ LIBOR submissions appeared to be so low compared to those of Barclays. Many of these concerns were based upon Barclays observations that other banks were making submissions which were lower than levels at which they appeared to be undertaking transactions. Subsequent research by the New York Federal Reserve staff members concluded that banks LIBOR quotes were systematically below their borrowing rates by 39 basis points after the Lehman bankruptcy.”

The BBA insists that its process is transparent and unambiguous. As all contributing banks are regulated, the BBA argues that regulators are responsible for individual bank’s behaviour. The BBA knows each person responsible for submitting information and can demand to see the actual trades on which these figures are based. No evidence that this was done has been disclosed.

The UK FSA does not have a specific regime governing LIBOR submissions, relying on broad rules governing identification and prevention of conflicts of interest.

Increased oversight and regulation of the rate setting mechanism is proposed.

Proponents of “narrow” banking argue that the separation of commercial and investment banking would solve the problem. But interest rate benchmarks affect normal lending and deposit taking activity as well trading activity. Proponents of the Volcker Rule argue that preventing proprietary trading by banks would minimise the problem. In reality, manipulation was not only related to trading positions but general banking activity.

UK regulators seem resistant to more stringent regulations. BoE Governor Mervyn King noted: “The idea that one can base the future calculation of LIBOR on the idea that ‘my word is my LIBOR’ is now dead”. But the Governor cautioned that: “I think it’s very important that people don’t expect too much from regulation”.

UK authorities nostalgically hanker for an anachronistic time when most bankers in London were located in the Square Mile of the City and relied on mutual trust. According to folklore, nothing more than a central-bank governor’s raised eyebrows was necessary to prevent unsatisfactory conduct. The good old days were not what they seemed. In the 1980s, the head of a UK merchant bank told new employees that he didn’t know how they would get rich given that insider trading was being banned.

A battle between major financial centres underlies the regulatory debate. In the 2000s, London became the world’s dominant finance hub. Non intrusive, market responsive “light touch” regulation was a factor in its success. Damage to London’s reputation and stricter regulation would allow New York and European centres to regain competitive ground. US authorities hinted that they forced reluctant UK regulators to act and are at the forefront of driving reform. European Union banking and anti-trust regulators have launched major investigations which may affect London’s competitive advantage.

Fixing the Fix…

Amusingly, a recent BBA review proposed no changes to the rate setting methodology, merely proposing a code of conduct and greater scrutiny of LIBOR’s correlation with other financial data over time. A “shocked” BBA is now reviewing the process.

Given the large volume of transactions linked to the benchmark, it is essential that changes do not disrupt the operation of the market. Changes that affect legacy contracts may create significant legal problems.

There is agreement that the rates should be based on actual transactions rather than theoretical estimates. There should be independent oversight of the process. Banks should be required to segregate the function for fixing rates from other activity to prevent conflicts of interest. Rate submissions should be documented to provide transparency and an adequate audit trail.

The most likely approach is that specified by the US CFTC (Commodity Futures Trading Commission) in its enforcement order imposed on Barclays (see Table 2).

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Table 2
CFTC Three Factor Approach to LIBOR Submissions

The CTFC nominated the following a three factor approach:

1. Barclays’ Borrowing or Lending Transactions Observed by Barclays’ Submitters including:
1.1. Barclays’ own transactions in the market
1.2. Barclays’ transactions in other markets for unsecured funds, including, but not limited to, certificates of deposit and issuances of commercial paper
1.3. Barclays’ transactions in various related markets, including, but not limited to, Overnight Index Swaps, foreign currency forwards, repurchase agreements, futures, and Fed Funds.

2. Third Party Transactions Observed by Barclays’ Submitters including:

2.1. Transactions executed by third parties in the market
2.2. Transactions executed by third parties in other markets for unsecured funds, including, but not limited to, certificates of deposit and issuances of commercial paper
2.3. Transactions executed by third parties in various related markets, including, but not limited to, Overnight Index Swaps, foreign currency forwards, repurchase agreements, futures, and Fed Funds.

3. Third Party Offers Observed by Barclays’ Submitters including:

3.1. Third party offers to Barclays in the market
3.2. Third party offers in other markets for unsecured funds, including, but not limited to, certificates of deposit and issuances of commercial paper, provided to Barclays by interdealer brokers (e.g., voice brokers)
3.3. Third party offers provided to Barclays in various related markets, including, but not limited to, Overnight Index Swaps, foreign currency forwards, repurchase agreements, and Fed Funds.

The CFTC guidelines also allow adjustment of LIBOR submissions having regard to the following factors:

1. Time: proximity in time to the Submission(s) increases the relevance of that Factor;
2. Market Events: Barclays may adjust its Submission(s) based upon market events,
3. Term Structure: if Barclays has data for any maturity/tenor described by a Factor, then Barclays may interpolate or extrapolate the remaining maturities/tenors from the available data;
4. Credit Standards: adjustments may be made to reflect Barclays’ credit standing and/or the credit spread between the market. Additionally, Barclays may take into account counterparties’ credit standings, access to funds, and borrowing or lending requirements, and third party offers considered in connection with the above Factors;
5. Non-representative Transactions: To the extent a transaction included among the Factors above significantly diverges in an objective manner from other transactions, and that divergence is not due to market events as addressed above, Barclays may exclude such transactions from its determination of its Submission(s).

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The process is detailed and prescriptive. The fact that it is binding on Barclays means effectively that it is likely to be basis of changes in the existing methodology. Consistent with cross border turf battles and ambitions, the CFTC may have succeeded in usurping control over a London institution.

But the changes pose different problems.

While basing LIBOR on actual transactions is desirable, the theoretical benefits may be difficult to achieve in practice due to the shrinking size of the market and reduced activity levels. As Sean Keane, a former head of Money Market Trading at Credit Suisse, wryly observed: “…over the last 4 years there have been fewer actual transactions in the unsecured cash market than there have been discussions about how to reform LIBOR”. Where trading is disrupted as in 2007/2008, it is unclear how an accurate submission can be determined.

As differences in bank credit ratings and quality increases resulting in greater variations in borrowing costs, LIBOR rates will become variable and less meaningful. Instruments suggested by the CFTC to calibrate submissions in the absence of money market transactions ignore the creditworthiness of the bank. These include OIS, futures contracts and collateralized currency transactions or repos.

Membership of a LIBOR fixing panel, once considered prestigious, may no longer be attractive. Constant regulatory and public scrutiny as well as risk of criminal and civil prosecution outweighs benefits. If banks become reluctant to participate in the process then the importance and acceptance of the benchmark will decrease.

For loans and deposits, banks may move to internal rates, which reflect their cost of borrowing. The biggest effect will be on derivatives transactions.

Created in simpler times, LIBOR was designed for pricing loans and deposits. Over time, derivatives based on LIBOR have become dominant. Perversely, the cash market on which LIBOR is based now supports a vastly larger derivatives market. Curiously, generations of quantitative experts have built elegant models based on advanced mathematical techniques to price complex derivative instruments on a deeply flawed and easily manipulated base.

Christoph Rieger, Head of Fixed Income Strategy at Germany’s Commerzbank, told a reporter: “LIBOR is not a market interest rate. The spot fixings are at best bank guesses of a hypothetical interbank borrowing rate. For that reason, this will always be subject to controversy”. Given this fact, a UK member of parliament Steve Baker asked the obvious question: “Members are increasingly wondering how such a large industry has been allowed to grow up on such a finger-in-the-wind number”.

In the Fix…

Barclays faces further prosecutions, including possible criminal charges. There are (up to) 20 other banks under investigation.

Civil suits, including class actions brought on behalf of affected parties, are likely. Assuming rates were set too low investors whose returns were reduced may seek redress. Parties to derivative transactions where payments increased as a result of low LIBOR levels may seek to recover losses.

Many American corporations and municipalities entered into interest rates swaps where low rates would have resulted in significant losses. The International Monetary Fund estimates the amount lost by municipalities at US$250 billion to US$500 billion in 2010. If successful action is brought under US anti-trust regulation, then banks may be liable for punitive triple damages.

Investment bank Morgan Stanley estimates that losses to banks could total (up to) US$22 billion in regulatory penalties and damages to investors and counterparties, equivalent to around 4-13% of banks’ 2012 earnings per share and 0.5% of book value. In reality, it is difficult to accurately quantify potential losses.

Other rates and prices set by banks will come under scrutiny. The US DoJ is prosecuting US energy trading companies for allegedly submitting false trade data to Platts and other publishers of price indices used to price and settle natural gas transactions.

There is now significant uncertainty about potential litigation and unquantifiable losses faced by banks. Already facing weak earnings, asset quality problems, higher funding costs and increased regulations, banks are likely to remain under severe pressure.

Fixing Banality….

Described by Lord Mandelson as “the unacceptable face of banking”, Mr. Diamond is an ideal villain. The fall of a brash American not noted for humility provides a suitable narrative arc. His statement to the UK House of Commons Treasury Committee that the “period of remorse and apology for banks… needs to be over” now smacks of hubris.

Betrayal and fractured friendships are evident. Mr. Del Missier, one of Mr. Diamond’s trusted lieutenants, insists that he acted on instructions from his CEO sanctioned by the BoE in ordering staff to submit false rates. Deputy Governor Paul Tucker and FSA Head Lord Turner are using the occasion to avoid collateral damage and burnish reputations in their rivalry for the high office of BoE governor. Suggestions of senior government officials and ministerial involvement add political intrigue. The contest between great nations seeking to dominate global finance provides a suitable background.

But the LIBOR fix may be a simple example of “beezle”. Coined by Economist John Kenneth Galbraith, the term describes the fraud or embezzlement that occurs in booms as sharp people take advantage of the favourable conditions and abundance of money.

Like mis-selling of complex products and the inability to manage risk, the manipulation of LIBOR reemphasises the deep seated problems of large banks and global finance. A review of the role of finance in modern economies and societies is overdue. Unfortunately, recent history suggests the political will for the necessary corrective actions may not be present.

But like Al Capone who was ultimately convicted of tax offences, banks may yet find that the LIBOR fix forces significant changes to banking regulation and practice. In an age of super computers and complex financial instruments, it would be a delicious irony if banks were to be undone by something as banal as an ancient rate setting process.