What Did He Know And When Did He Know It?

This paraphrase of the famous question posed by Senator Howard Baker during the Watergate scandal is one that can and should be directed to a number of people as the Barclays LIBOR scandal unwinds. Former Barclays president Bob Diamond’s testimony following his resignation is tantalizing, both because of the information that has come out and the myriad of unanswered questions that remain.

The facts are still sketchy in a number of dimensions, but some are clear. The people responsible within Barclays for providing the daily LIBOR fixing to Thomson Reuters, on behalf of the British Bankers Association (BBA), knowingly submitted inaccurate information at times. In part, the false submissions were in response to pleading from derivatives traders seeking to protect positions that could be affected by the spreads posted across dollar, yen, and euro LIBOR rates of differing maturities. This raises a host of questions about internal conflicts of interest within the firm, what was known about the illicit process, and why management responsible for the submissions tolerated the behavior. Then there is the implication that the falsification of LIBOR rates was not only being practiced by Barclays but also by other institutions. The FSA June 27th materials accompanying the imposition of a £59.5-million settlement in connection with the LIBOR fixing contain emails and documentation of phone conversations that clearly show that some of the requests to lower the posted LIBOR rates came from outside the firm and, equally, that some of Barclays’ people were making similar requests of other institutions. On this issue we have not yet begun see the underbelly of what traders were doing or what other institutions were involved.

The Baker question should surely also be asked of the Bank of England’s Deputy Governor, Paul Tucker, who reportedly had conversations about the risks that Barclays faced during the financial crisis and the government’s fear of the possible need to nationalize the bank, because of the high rates Barclays was posting. We don’t know yet know the Whitehall officials on whose behalf Deputy Governor Tucker was acting, or what their concerns or suggestions were in terms of the posting of rates, but these facts will surely emerge in coming days.

The Baker question should also be posed to FSA officials who were supposedly put on notice that misreporting of LIBOR rates was widespread. Questions had been raised about the whole process long before the financial crisis, not only to FSA but also other regulators. What did the FSA and other regulators know and why didn’t they act?  Barclays’ documents suggest that the FSA may have even condoned the reporting of lower rates. The FSA was notorious for its lax policies, and its behavior in the Northern Rock situation was simply another example of a regulator essentially not doing its job.

Speaking of who knew what when, there are tantalizing suggestions that other regulators outside the UK were also aware of irregularities in the Barclays LIBOR data, including the Federal Reserve. Barclays Capital is a primary dealer and is authorized to deal directly with the Federal Reserve’s Open Market Desk. So the Fed had every reason to be concerned if information had surfaced about irregularities in the LIBOR fixing process. Similarly, several major US banks were also suppliers of daily information on LIBOR, so one wonders who and what institutions might have also been engaging in behavior similar to that of Barclays.

At the hearings, Bob Diamond appeared at times to be totally out of touch with the concerns that his questioners were expressing when it came to the internal corporate culture and governance processes within the bank. He suggested that only a few traders were involved, and he deflected criticism of the lack of oversight of the LIBOR reporting process, characterizing it as one that did not involve significant risk to the company. But he was myopically focused on financial risk, though, as the day’s events have revealed, the reputational risk has proved to be huge and its realization devastating to Barclays, to Diamond’s career, and to those of other senior management. Yet Diamond never seemed to connect the dots.

As for the Barclays culture, the emails and quotes from phone conversations in the FSA document clearly show that there was a cowboy mentality at work, driven by short-term profits on trades that were in turn likely influenced  by the compensation and bonus schemes in place, with no regard for risk-adjusted returns. While this author is not in favor of governments dictating compensation schemes, I have argued in a recent paper with Christine Cumming, First Vice President of the Federal Reserve Bank of New York, that there might be merit in trying to emulate some of the governance controls that previously existed within investment banks when they were partnerships. In a partnership, returns and a partner’s wealth are inexorably linked to the overall profits of the firm and the risks that other partners are taking. Thus, the partners have strong incentives to be concerned about all the other business their firm and the other partners were doing. Hence, partners are concerned about monitoring risk and the overall exposure of the firm. In that spirit we proposed that bonuses and incentive should only be paid out of consolidated entity profits and not the contributions of individual subunits or individual traders to overall returns, as is the current practice in most complex financial institutions.

There are also fundamental issues surrounding the concepts underlying the generation of the LIBOR data. The rates are simply the best guess as to what a firm might have to pay at 11:00 AM to raise funds of given maturities. They do not reflect actual  market  rates or trades. This is not the way Federal Funds rates are compiled. The current LIBOR process is obviously fraught with potential conflicts, as the Barclays events demonstrate, and should be immediately converted to an actual trade basis. The hundreds of trillions of dollars in transactions that are linked to LIBOR – even my own mortgage interest rate is linked to what now may be a bogus number – should concern us all.

Finally, little attention has been paid to the consequences the faulty LIBOR structure poses for markets, investors, and borrowers. Did the process bias interest rates significantly, and if so who gained and who lost in the process?  This question alone suggests the potential for significant lawsuits that potentially might affect not only institutions but the BBA and perhaps even governments.

We have just begun to see the dimensions and fallout likely to be associated with the LIBOR fiasco. As time and events unfold, we will continue to monitor and comment. For now, all that we ask is, “What did they know and when did they know it?”