LIBOR and Other Investment Banking Revelations

Following recent publicity and concerns about the scale of Barclays’ LIBOR (London Inter-Bank Offered Rate) rate fixing, other revelations continue to emerge.  These are all ‘bad news’ for many leading banks and investment banking generally, both in the UK and internationally. They are also a reminder that there is much in global banking that needs fixing and that more regulation by itself is not the complete solution.

Morgan Stanley’s analysis of the LIBOR scandal suggests a dozen banks (including Barclays) connected to the LIBOR issues could face up to tens of billions in combined regulatory penalties and damages.  These 11 other banks may face even higher penalties than Barclays, whose regulatory penalties were reduced because it cooperated at an early stage with the investigation. Barclays has already paid (in June) $45 million to US and UK authorities.  These admittedly crude estimates do not include potential penalties from the continuing EU and US cartel investigations, which could also bring multibillion dollar fines.

It has recently emerged that there was considerable concern with LIBOR rate setting at the highest US level during the height of the 2007-2009 financial crisis.  A powerful US committee gave a presentation entitled “Market concerns regarding LIBOR.” The paper was circulated to the Interagency Financial Markets Group  (set up to deal with the global meltdown) on June 5, 2008.  This group included the US Treasury and it has raised concerns that the Bank of England did not act sooner.

US vs UK bank regulators

The US concerns were crystalized in recommendations by the US Federal Reserve boss Timothy Geithner on how the BBA (British Bankers Association) might improve the LIBOR rate-setting process.  US regulators appear to believe that the BBA did not act on these and that the Bank of England, despite allegedly agreeing they were ‘sensible’, did not put pressure on the BBA to do so.  Nevertheless, it  seems that the Bank of England (via its governor, Sir Mervyn King) did put considerable pressure on the BBA to show ‘greater energy’ in its review of LIBOR rate setting.

The Bank also emphasizes that the Geithner memorandum did not refer to any alleged wrongful behavior by Barclays or other banks. This apparent ‘tension’ between US and UK bank regulators is unusual and indicative of the international concern that the rate fixing debacle has unleashed. Hopefully, it will ultimately help to produce a strong US and UK response from  two of the most powerful international banking countries.

More allegations and revelations have also emerged.

Paul Tucker, deputy governor of the Bank of England, was summoned to the Common’s Treasury Committee a couple of weeks ago.  He was asked to explain his conversations and written exchanges with Bob Diamond, then Chief Executive of Barclays.  Tucker denied any kind of approval to manipulate interest rates.  He also refused to lend any support to the UK Chancellor George Osborn’s allegation that the former Labor City Minister put pressure on the Bank of England to manipulate LIBOR during the crisis.  This is denied strongly by the former Labor Minister.

This latter alleged manipulation had a ‘public good’ aspect in that British bank borrowing rates (LIBOR) in the money market were ‘reduced’ to make the banks look stronger. Such a move could have helped  to ‘steady the market’ at a time when it was fragile.

LIBOR is not the only problem

Hot on the heels of the LIBOR and other key benchmark rate scandals, more investment  banking problems and allegations of bad banking behavior keep appearing.  HSBC is set to appear before a US Senate investigative committee charged with a failure to prevent money laundering on a big scale. HSBC is also being investigated together with Germany’s Deutsche Bank and the French Societe General and Credit Agricole banks into the alleged rigging of LIBOR’s European equivalent, EURIBOR.

These revelations and allegations add to mounting concerns about the culture of investment banking and the regulation of banks.  An immediate response to the LIBOR ‘scandal’ has been calls for a more transparent process in LIBOR rate setting and a mechanism to link such key benchmark rates to actual, rather than estimated, rates in the market.

The cost of  excessive bank regulations

A wider, generic response to alleged bad banking behavior is a call for more constraining and punitive regulation.  But excessive bank regulation has its own costs, which may ultimately fall on its customers in the form of restricted bank lending availability, higher cost loans and fewer investment banking career opportunities.

At the same time, more restrictive regulation may also motivate banks to try and lessen the impact, or even avoid, a harsh regulation.  So called ‘shadow banking’ (investment banking that is unregulated) may then emerge.  The growth of this kind of ‘shadow banking’ was a significant factor in the build-up to the 2007-2009 financial crisis.

It is unrealistic to expect too much from more and improved bank regulations, needed though they may be.  In the UK, there is already a major regulatory reform of banks and financial services under way.  A new Financial Services Bill was published in February.  The ‘Vickers Commission’ has made important proposals on ring-fencing the retail and investment banking parts of a bank; increasing the ability of banks to meet unexpected losses; and improving competition.

Bank supervisory regulation in the future will be carried out by the Bank of England, rather than the FSA (Financial Services Authority). Among other advantages, this move will facilitate a wider ‘macro context’ in evaluating banking risk taking and risk exposures.

These initiatives are part of a raft of new bank regulatory developments and initiatives in the UK and internationally, like the new Basel 3 rules on international banking risks and their supervision. They are unlikely to be perfect and some may have unintended consequences.  Many of them will also take several years to implement.  Even if they all work ‘better than expected’, they are not enough by themselves.  A  fundamental problem that regulation alone cannot tackle is banking culture and bank governance.

A culture of aggressive profit-seeking

It is the attitudes and behavior of the people running the businesses that were major drivers of the excessive risk taking that characterized  the run-up to the crisis.  This is not just a British problem – indeed, many would argue that it is grounded in the excesses of a US investment banking culture.  Aggressive sales targeting, short-term profit maximization, an apparent casual approach to professional ethics and a lesser concern for customers and society at large typify this kind of culture.

This kind of culture is, in one sense, a product of strong deregulation moves in investment banking systems around the globe.  In countries like the US and UK where this type of deregulation has been especially strong, intense competitive pressures have been released.  These have helped in turn to spawn a culture of aggressive profit-seeking in many banks.

Initiatives to restore banking professionalism and integrity

Nevertheless, a great deal has been done, and more is being promulgated, to tackle this apparent problem of banking culture and to help restore the professionalism and integrity that banking has traditionally emphasized and enjoyed.  Good examples of this kind of initiative are the formation of the Chartered Banker Professional Standards Board, the City Values Forum and the Chartered Insurer’s Institute ‘Aldermanbury Declaration‘ in the financial city of London.

These kinds of initiatives recognize the banking and financial services industry’s reputation is ultimately shaped by the professional standards and managerial quality of those who run the business.  The recent revelations and scandals should give an added impetus for these much needed moves.  Ultimately, though, the industry itself and its regulators must fully own them. In order to succeed, these initiatives  must also be adopted and owned on a wider international scale.

Bank governance

Another and related core problem is bank governance.  Governance is concerned fundamentally with incentivizing and disciplining banks to act in the best interests of their key stakeholders. The recent financial crisis and the subsequent scandals confirm that bank governance is a serious problem and the present system is apparently unable to cope.

The Western ‘free market’ model’ is that shareholders are the key stakeholders and should discipline banks to act in a ‘value maximizing’ way (i.e., in shareholders’ best interests). But expecting shareholders alone to be capable of doing this appears unrealistic.  It also leaves out of the equation other important stakeholders, like society, taxpayers and bank customers.

Banks are not corporations.  Banks are subject to several kinds of necessary regulatory interventions, like access to central bank borrowing as ‘lender of last resort’, and the so-called ‘too big to fail’ doctrine that enable them to take bigger risks than other kinds of financial firms.  When these risks ‘come home to roost’ in a crisis, tax payers ultimately have to bail banks out.  This kind of ‘one way bet’, where banks take the profit when things go well and taxpayers bear the costs when there is a financial crisis, confers on banks a special role in economic systems and a greater accountability and responsibility to society at large.

In this context, the UK Treasury has recently proposed that bankers should face trial under a so-called ‘Fred’s law’, a reference to former boss, Fred Goodwin, of the UK Royal Bank of Scotland.  Under this ‘Fred’s law’ proposal, the bosses of a failed bank that took excessive risks may face prosecution (and prison) for criminal recklessness.  This is a strong and necessary move towards  developing a governance system that recognizes banks are ‘special’ and that this specialness confers regulatory privileges and greater societal responsibilities.

The ‘good news’ is that these latest revelations and allegations may provide the final ‘nail in the coffin’ for  the kind of pre-crisis investment banking that was a significant element in the scale and intensity of the recent financial crisis. Society increasingly demands these changes  and regulators now have a stronger mandate than ever before to act.

Written by Ted Gardener

Ted is a Professor in Economics who writes about the latest economic developments around the globe, he is chief economics writer for an international serviced offices provider.

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