The Libor scandal solutions are being discussed by the regulators in the US, the UK and the EU. Proposed Libor regulation options include abandoning Libor in its entirety, replacing it by the overnight swap index rate and making rate manipulation a criminal offense. Finally, replacing Libor could invalidate trillions worth of financial contracts that were based on the Libor rate.
However, regulators fail to consider revising the structure of the banking industry to remove conflicts of interest that lie at the core of this and many previous scandals.
For decades people assumed that banks reported the rate honestly and relied on it to set the price of many contracts (mortgages, credit cards, student loans) as well as $350 trillion worth of interest rate and currency swaps. However, the Libor rate setting process is private and overseen only by the banks themselves through the British Bankers Association (BBA).
And it’s no coincidence that two thirds of the banks are global banks with large investment banking and retail divisions. Further, most managing members at BBA are former CEOs of the banks and disciples of Wall Street. This obviously creates a conflict of interest embedded into the Libor model as an array of financial firms, mortgage lenders and credit card agencies set their lending rates based on Libor.
And it is especially lucrative since banks still can engage in proprietary trading and hedge against market risk and interest risk on their debt by using derivatives such as interest rate swaps. For example, to hedge the interest risk on the debt institution can swap a floating rate for a fixed rate and make periodic “reset payments” to the bank to balance any fluctuations. If Libor falls, the reset payments decrease and vice versa. So, it is easy to see how the enticement to manipulate Libor is huge and even a single basis point distortion of Libor rates across the board has enormous financial impact.
Although, it does not prove manipulation, it certainly exposes strong conflict between the incentives of banks running a derivatives book worth in trillions that engage in commercial bank behavior and self-regulatory agencies such as BBA.
And perhaps, if the conflicts of interest at the root of recent financial scandals, it only begs the question as to whether the financial crisis and the array of scandals could have been avoided had the Glass-Steagall Act not been repealed back in 1999.
