Libor rigging losses another’s gain
SIR — David Gleason wrote a remarkable primer on the Libor scandal (Libor a little part of interest rigging, July 26) which serves as recommended reading for anyone trying to understand this crisis.
What may confound some readers is what the impact of rigging the Libor rate by a fraction of a basis point translates to in the real world. To add more perspective to this question, we can turn to research done by Morgan Stanley on this question.
It is worth putting into numerical value what the Libor rate is. It is the reference rate for about $350-trillion of financial products. Morgan Stanley estimates that Libor rigging could possibly account for $720m of profit for each of the banks under investigation over a four-year period. The obvious question would be why would banks wilfully turn a blind eye to this? The answer is simple: greed. Compensation as a percentage of investment banks’ revenue is typically 40% to 50% of their profit, and Libor rigging serves this self-interest.
The counter-intuitive paradox of this scandal is that the Libor rate was low-balled (underpriced) in some cases. So shouldn’t we be happy that rates were artificially low? No. In financial market trades, one trader’s loss is another’s gain. And in this situation it is easy to envisage large institutional investors such as pension funds who potentially lost money through lower (than would have been) investment returns. Their returns have a real impact on the lives of millions of pensioners.
Mr Gleason questions the merits of reintroducing the Glass-Steagall Act (1933) that separated commercial banks and investment banks. I agree with him and submit that financial engineering in the banking industry has reached a level of sophistication that would make the act impotent. Besides, the banking crisis of 2008 began in an investment bank (Lehman Brothers) and an insurance firm (AIG). A structural separation of investment banking from commercial banking in the absence of regulating their activities is no different from a doctor applying a Band-Aid to a haemorrhaging patient.
An interesting solution that has been proposed by the economist John Kay is to broaden fiduciary-duty standards in banking. For example, in a 2007 case, Goldman Sachs created a collateralised debt obligation (CDO) designed to fail, and hedge-fund honcho Paul Johnson helped pick a reference portfolio of ailing mortgagebacked securities so he would reap huge profits on his short position. Goldman did not disclose to the insurer of the CDO John Paulson’s economic interest in the CDO failing. A higher standard of fiduciary duty would have compelled Goldman to act solely in the interests of its client.
It also makes it easier for clients to sue institutions where this duty has been breached.
So, as Mr Gleason asks, what happens next? The answer is very predictable. Banking reform will be a political issue of which the incumbent US president and Mitt Romney will steer clear for the rest of the year. Regulators in Europe and the US will continue to be victims of regulatory and intellectual capture.
In 2013, Jamie Dimon and his fellow bankers will commence their annual pilgrimage to a television screen in front of you extolling the virtues of the banking sector and justifying their even bigger bonus pot. The rest of us will either suffer from collective amnesia or will be asking “What the Libor” was the fuss all about?