The days between the Fourth of July and Bastille Day on the 14th are known for fireworks on both sides of the Atlantic. This year, more rockets and firecrackers than usual were going off, but they were inside hearing rooms in the British Parliament and the U.S. Congress. Barclays bank announced that it had been fined more than $450 million by regulators from both countries, and its CEO, Robert E. Diamond Jr., and COO, Jerry del Missier, both resigned. The fines were part of a settlement that granted Barclays immunity from potentially worse punishment for its manipulation of interest rates. The press reported that 10 to 12 other large banks (including HSBC, Citigroup, and JPMorgan Chase) were also under investigation.
The big financial scandal of July 2012, or at least its first half, involves manipulation of the London Interbank Offered Rate, or LIBOR. The press has used a variety of estimates of the impact of LIBOR, ranging as high as $500 trillion (the Bank of England estimate) to $800 trillion in loans, securities, and derivatives that are linked to the LIBOR index. (For perspective, the 2011 gross domestic product of the entire globe was only $70 trillion, according to the World Bank.) These estimates may well be vastly understated, because they appear to exclude the huge currency markets (with turnover of $3 trillion to $4 trillion per day). The difference in value between U.S. dollars and euros is largely a function of the difference between dollar LIBOR and euro LIBOR, though the effect is not explicit as in a loan indexed to LIBOR.
Whatever calculations are used, the numbers are simply staggering. LIBOR represents the cost of money. It affects mortgages and credit cards as well as corporate bonds and loans since interest rates are almost all pegged to LIBOR.
The financial world is seeking to place blame in the LIBOR scandal to divert attention away from the bad behavior of the banks. Their spin managers will want to make the proceedings and the media coverage into a discussion of regulatory failures. There is little doubt that regulators were both inattentive and complicit, and a thorough investigation of their failures is in order. However, regulators did not manipulate LIBOR; banks did. Their culpability and schemes to deceive the markets and the public must not be obscured by the search for what regulators knew and when they knew it.
Barclays and other banks manipulated LIBOR in two distinct ways. First, they engaged in price rigging—biasing the daily LIBOR index either higher or lower and simultaneously colluding with traders to turn a profit on the prior knowledge of the bias. This activity was fundamentally larcenous, and Barclays settled its liability to avoid further punishment for defrauding the market by rigging prices.
The second thing they did involved more nuanced moral choices. As Barclays struggled to survive, it reported interest rates on its borrowings in the LIBOR process that suggested that the bank was less fragile than it was (a practice known as “dressing up bank credit”). This dishonesty must be viewed through the filter of an organization that fears its mortality. Since it was undertaken to mitigate the day-to-day perceptions of bank soundness in the midst of the crisis, it was not necessarily a behavior that would be repeated. It is likely that management justified it as a step to calm a panic. While wrong, it was somewhat less reprehensible than the trading scheme.
But both the price rigging and the reports on the interest rates were massive deceptions on the public. The banks and the individual employees that engaged in the practices may well face criminal penalties if the ongoing Department of Justice inquiry bears fruit beyond the Barclays settlement. The Justice Department has been working alongside U.S. regulators for two years to investigate the manipulation of interest rates.
Regulators in the United States and Great Britain failed to perform their duties (with the exception of the U.S. Commodity Futures Trading Commission under the leadership of Chair Gary Gensler). Reports have made clear that regulators were aware that Barclays (and perhaps the other banks) were dressing up bank credit during the crisis. Treasury Secretary Timothy Geithner even claims that he corresponded with U.K. regulators on the practice and urged action. In that period, regulators were primarily concerned that a chain reaction of bank failures would trigger another Great Depression. While dressing up bank credit was misleading to investors and to regulators not in the know, the need to protect the system from meltdown was a legitimate concern.
If regulators turned a blind eye to price rigging, that would be a much different matter. No public interest is served when traders use non-public information to secure trading profit without risk. Corrupting the interest-rate markets undercuts their credibility in ways that hurt consumers of credit, individual and corporate.
Above all else, a discussion of the effectiveness of regulation and the judgment exercised by regulators must not distract the public and the press from the activities of the banks. The system depends on the reliability of information that the banks report. Lying to regulators, either directly or indirectly, cannot be tolerated. The potential to turn a quick profit in the markets makes it easy to cut corners and even lie. The payoff from this behavior is large, immediate, and certain. The consequences must be proportionately certain and severe.
The LIBOR scandal is likely to endure for months as bank after bank agrees to a settlement of the investigations. This and the complexity of the issue could cloud the underlying truth: To turn a buck, banks throughout the world were willing to lie about critical data, and they should face the lawful consequences of their actions.