Libor And Public Governance

Recently I wrote about the sorry state of corporate governance in some leading financial institutions that is being revealed by the still-developing LIBOR scandal. We now have, in addition, the US Senate report charging that the lax guidelines of HSBC affiliates worldwide failed to guard against money laundering, doing business with firms linked to terrorism, and bypassing sanctions against Iran. Thus we have more damage being done to confidence in the major global banks. In this note we turn to some public governance issues raised by the LIBOR scandal. Did central banks and the relevant regulatory bodies, along with the international bodies responsible for overseeing the global financial system, respond to the problems in the ways we should expect?

One broad measure of what we should expect at the public governance level can be found in the OECD Principles of Corporate Governance that I cited in my previous note. Recall that these Principles have been endorsed by the governments of the 34 member countries of the OECD, including the US and the UK, as well as the World Bank and the IMF. Principle I.D states, “Supervisory, regulatory and enforcement authorities should have the authority, integrity and resources to fulfill their duties in a professional and objective manner. Moreover, their rulings should be timely, transparent and fully explained.” We will focus on the second sentence of this Principle.

It has become evident that a number of national regulatory agencies and central banks were aware of the problems with LIBOR and the possibility of abuses well before the present year. My colleague Bob Eisenbeis has written about staff members of the New York Federal Reserve Bank having discussions on the matter with staff of Barclays in December of 2007. The then President of the NY Fed, Timothy Geithner, “spoke briefly" (his words) on the subject with Mervyn King, Governor of the Bank of England, in Basel, Switzerland, where both attended the monthly gatherings of central bankers at the Bank for International Settlements (BIS), considered to be “the central bank for the central banks.” On June 1, 2008 Geithner sent an email to King offering six “Recommendations for Enhancing the Credibility of Libor” that had been developed by the staff of the New York Fed. King replied that the recommendations “seem sensible to us” and that he was passing them to the British Bankers Association (BBA), which is responsible for the daily LIBOR fixing. On May 1, 2008 the New York Fed also briefed the Federal Reserve Board and relevant regulatory bodies, in particular, the Commodities Futures Trading Commission, which had already opened an investigation the previous month, and the Securities and Exchange Commission. As far as these steps go, they are commendable. But did they go far enough?

On July 20 the Bank of England released on its website a large amount of correspondence between the Fed, the BOE, the BBA and the UK’s Financial Services Authority (FSA) that sheds information about the BBA’s review of LIBOR in 2008. Clearly in the period following the receipt of Geithner’s recommendations, the BOE and the Fed continued to interact with the BBA, seeking to shape the final results of the Libor review while not wishing to be seen as endorsing those results. The BBA did not seem to think anything was really wrong with LIBOR but they recognized they had a serious perception problem that they needed to be seen as addressing. The BOE appeared to be more concerned that LIBOR had deficiencies that needed to be addressed in order to make sure that LIBOR would not be replaced by a New-York based alternative. There are no indications in this correspondence that anyone felt they were dealing with a problem of systemic importance. Nor is there any suggestion that either the Fed or the BOE were unsatisfied with the modest results of the review, which only partially took on board the Fed’s recommendations.

Last week, Mervin King, under fire for not acting sooner, charged that Geithner gave no indication of malpractice in their 2008 exchange. In their July 20 posting on their website, the BOE adds “At no point did the FRBNY draw the attention of the Bank to evidence of wrongdoing in the setting of BBA Libor. Indeed, with the exception of the memorandum sent by Mr. Geithner to the Bank in early June 2008, none of the other documents published on June 13 2012 by the FRBNY had been shared with the Bank. These showed, inter alia, that back in April of 2008 a Barclay’s staff member advised a New York Fed staff member that the bank in the UK was low-balling rates to avoid appearing weak. Fed Chairman Bernanke testified last week that in 2008 they had no information that bank traders had tried to manipulate rates “for profit.” However, both the Fed and the BOE certainly should have been aware by then of the potential for such manipulation.

In addition to warnings in academic papers and the NY Fed’s own research, it is notable that the March 2008 issue of the BIS Quarterly Review included an article, “Interbank rate fixings during the recent turmoil,” by two BIS economists, Jacob Gyntelberg and Phillip Wooldridge. They say the following:

“The widespread use of fixings as reference rates also gives contributing banks an incentive to misquote.… For example, market participants with large positions in derivative contracts reference a rate fixing might seek to move the fixing higher or lower by contributing biased quotes. Alternatively, they might indirectly influence the accuracy of the fixing by choosing not to join the contributor panel.”

The scope for such strategic behavior to influence the fixing can to some extent be limited by trimming, in which biased or extreme quotes are disregarded. However, even trimmed means can be manipulated if contributor banks collude or if a sufficient number change their behavior.”

Last week Bernanke testified that, “The LIBOR system is structurally flawed … It is a major problem for our financial system and for confidence in the financial system … we need to address it.” He emphasized that this will require an international effort. We would agree. It seems doubtful, however, that either US or UK authorities recognized until very recently that the problem was major, of systemic importance, even though regulatory investigations have been underway since 2008 in the US; and now reportedly at least 10 enforcement agencies globally, including those in Canada, Japan, Europe, and Korea have investigations underway. There appear to have been no efforts to raise the issue in key international financial forums, in particular, the BIS, the Financial Stability Board, the IMF, or the OECD, all of which could have been used to increase awareness of the problem and exert pressure for reform. Until the recent revelations, there has been no effort of which we are aware to inform investors or the general public that a benchmark rate central to the plumbing of the financial system was structurally flawed.

Indeed, the opposite signal was given as the Fed continued to use the LIBOR as a benchmark. In September 2008 the NY Fed extended to AIG an $85 billion line of credit with an interest rate based on the LIBOR. In November 2008, when the Fed established the Term Asset-Backed Securities Loan Facility, it again used the LIBOR to set the interest rate. Now, five years after the first warnings were given, all the relevant public-sector institutions are picking up the ball. Regulatory and enforcement bodies are carrying out investigations, some of which are well-advanced. Mervyn King has arranged for a meeting September 9 in Basel, bringing together central bankers to discuss LIBOR deficiencies and consider “radical reforms.” Also, Mark Carney, governor of the Bank of Canada and chairman of the Financial Stability Board, said the FSB will look for long-run solutions to the LIBOR problem. The FSB brings together bank regulators, finance ministers, and other financial supervisors under a mandate to coordinate at the international level the work of national financial authorities to develop and promote the implementation of effective regulatory, supervisory, and other financial-sector policies that have implications for financial stability.

It is a pity that it took five years and the Barclays case to bring this degree of attention to the issue. Referring back to the governance Principle cited in the second paragraph, we certainly cannot give a high grade for transparency. As for timeliness, the NY Fed got off to a good start, but the follow-up by the Fed after 2008 was lacking. As for the Bank of England and the UK’s Financial Services Authority, the defense that the US did not provide a sufficient warning about deficiencies in the LIBOR seems weak to us. It is unfortunate that the Bank of England apparently was not informed by the NY Fed of information it had obtained about practices at Barclay’s in London. However, as the LIBOR system is based in the UK, the BOE and the FSA must have been aware of the structural flaws, but apparently did not recognize their systemic importance.