The LIBOR Scandal and Regulators Who Knew

The headline in Saturday’s New York Times said it all: “New York Fed Knew of False Barclay’s Reports on Rates.” The article quotes a Barclay’s employee telling a New York Federal Reserve official in April 2008 that “we know we’re not posting, um, an honest rate.” Thus far, Barclay’s is the only bank of the nineteen that daily set LIBOR to admit their wrong doing. Three American banks – Bank of America, JP Morgan and Citigroup – are among those who daily submit quotes. Its importance to LIBOR (London Interbank Offered Rate) is that, according to Republican Congressman Randy Neugebauer, chairman of the House Financial Services Subcommittee, about $800 trillion in financial products are pegged to its rate.

On a per loan basis the difference of a few basis points is so small as to be negligible, but a bank’s proprietary derivative trading is done with enormous leverage, and therein lies the problem. These desks borrow capital all the time, in the market or from themselves, and then leverage it up multiple times. One analysis that I read suggested that manipulated LIBOR rates could have resulted in excess annual compensation for derivative traders, on a per bank basis, of $290 million to $360 million, or an average of $2.9 million to $3.6 million per trader over the same four years.

Certainly, bankers who are deemed guilty of falsifying rate estimates, especially when linked to derivative trades, should be prosecuted, but so should regulators who knew what was going on and did nothing. An editorial, in the same issue of the New York Times, “What They Knew or Should Have Known,” points out that the settlement last month between Barclays and the Department of Justice noted that rates “were too low” and did not reflect the market. They also make clear that when regulators were told of the situation, in early 2008, they did nothing to stop the false reporting.

They conclude, somewhat irrationally, by implying that Treasury Secretary Timothy Geithner (then President of the New York Fed) deserves a pass – that he had passed this information on to British authorities who did nothing. Certainly the British Bankers Association and Britain’s Financial Services Authority (FSA) bear the bulk of the responsibility. Nevertheless, three of the banks involved in setting LIBOR fell under Mr. Geithner’s purview. Regulators are supposed to regulate; they need to be held responsible when malfeasance is afoot.

(As an aside, last week watching Parliament’s Treasury Select Committee interview Barclay’s outgoing Chairman, Marcus Agius, I had the distinct impression that Mr. Agius and Members of Parliament were throwing Barclay’s American CEO Robert Diamond under the bus. Mr. Diamond has already resigned and has foregone, or had clawed back, £20,000 in compensation. It is also difficult to believe that Barclay’s was alone among the nineteen banks to fiddle with their LIBOR quotes. On the other hand and in contrast to the U.S., Parliament is scrutinizing the Financial Services Authority, their equivalent of our SEC.)

A similar situation existed when the SEC and the CFTC, which had repeatedly been made aware of suspicious trading at Bernie Madoff’s firm, MF Global and scores of others. Regulators have routinely failed to enforce existing rules. Neglect and/or ineptitude appear to be the culprits in the case of the SEC and the CFTC, though one should not rule out the possibility they were accessories. Our financial system is based on credit and credit relies on trust. When trust disappears, so does credit and when that happens, business grinds to a halt.

Madoff stole money by falsifying records for years, deceiving those who had entrusted him with their funds. MF Global apparently merged customer and house accounts, which is also known as stealing. Despite warnings, neither firm’s misdeeds were caught until it was too late. There is little doubt in my mind that Corzine should go to jail, but so should the regulators who failed the public with their ineptitude, or worse.

But the problem goes far beyond greedy bankers and ignorant and/or complicit regulators. Congress made deliberate policy decisions to encourage risky behavior, not only on the part of consumers, but on the part of the government sponsored enterprises (GSEs) for which they had oversight, especially Fannie Mae and Freddie Mac – businesses that developed symbiotic relationships with those politicians charged with their oversight. House Financial Committee Chairman, Barney Frank and Senate Banking Committee Chairman, Chris Dodd are as responsible as anyone for the credit collapse that nearly brought down our financial system.

While President George Bush gets most of the blame for the crisis, the fact of the matter is that he tried on numerous occasions to rein in the activity of these run-away GSEs, notably in his first budget in 2001 and as part of a comprehensive GSE reform in 2005, pushed by Republican Senator Richard Shelby, but which failed under a filibuster threat from Senator Dodd. Bush’s reform package was finally passed in 2008, but that was after the two entities had failed. Mr. Frank and Mr. Dodd both chose, wisely, to vacate the scene, but both should be indicted for the harm they did.

The response by Congress and regulators is never to look in the mirror for cause; it is to write new regulations, essentially red herrings, to divert attention from their own cronyism. In the weekend edition of the Wall Street Journal, former Secretary of State George Schultz spoke of Congress’ habit of passing bills thousands of pages long, bills that they have never read, so they literally never know what they contain. The response of too many in Congress to actions they have helped promote is to promulgate a culture that fails to take personal responsibility for any unintended (or even intended) consequences of those actions. People, right or wrong, do take direction from their leaders. Too many of ours have failed us. Honor, duty, high moral standards remain only gossamer threads of a bygone era.

A failure to take responsibility for one’s actions causes a blurring of the distinction between honest misjudgments on the one hand and deliberate malfeasances on the other. Most people play by the rules. But they need to know two things – what are the rules, expressed as simply as possible, and they must know that rules will be enforced, so that violators will be outed. When the SEC, CFTC and Congress look the other way, for favored constituents, it encourages misbehavior.

Congress has spent hundreds of thousands, if not millions, of man hours producing two new laws filled with thousands of new regulations, yet the regulatory bodies that exist have abysmally failed their responsibilities – not because they did not have teeth, they did, but because regulators chose to look the other way.

Most of the press’s ink spent on recent scandals has focused on greedy, immoral, and vacuous bankers. There is little doubt that many of the accused are likely guilty, yet too many go free. Political connections have fostered an unusual level of cronyism. But the press should not overlook the fact that regulators did not regulate, nor should they leave untouched those in Congress and the executive branch who encouraged reckless behavior, on the part of consumers and the GSEs. A restoration of confidence is needed before markets will be able to function normally. At present, there is too much distrust between Wall and Main Streets. Vilifying one while praising the other only deepens the chasm and exacerbates the divide. Placing blame where it lies is the only answer.

This is not rocket science; it’s common sense. The rules are simple. In a partnership, the partners have their capital at risk. In a public company, management has a fiduciary responsibility to the shareholders that own the company. And public employees, no matter where they work in government, have a responsibility to taxpayers to treat their money with respect and care. Before writing new regulation, check out the regulators and check out their Congressional sponsors. 


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