Incentives to Lie

Michael Douglas's infamous line, “Greed is good,” in the movie Wall Street provides a partial explanation of the incentives to “misreport” the numbers—the profit motive. After the repeal in 1999 of the Glass-Steagall Act of 1933, large banking institutions were no longer barred from trading stocks, bonds, and other investments. Because the prices of many of these financial instruments fluctuate with interest rates—for example, when interest rates increase, the price of bonds decreases, and vice versa—Libor-participating bankers could position their investments for their own gain if they manipulated rates.

But there's another reason why banks might be motivated to understate the rate that they pay to borrow from each other. As the most recent financial crisis demonstrated, the realized and unrealized losses on banks' balance sheets from subprime mortgages caused a credit freeze among major lending institutions. According to media reports, some institutions' Libor submissions were as much as 30 basis points lower than their actual borrowing costs in order to make them appear economically stronger than they were. Interest rates are directly related to risk—if a bank is a lower credit risk, its interest rate should be lower. In this case, attempts at transparency in the Libor process seem to have worked against reliable reporting.

Fixing the Problem

Regulators in the United States and United Kingdom have both indicated that the current Libor system is “structurally flawed” and no longer “viable”; however, getting rid of Libor is perceived by many as too disruptive for the global financial system (see the BBC's report at http://www.bbc.co.uk/news/business-18671255). Recommendations by the United Kingdom's Financial Services Authority (FSA) include the following:

• Stripping the BBA of the authority to manage the rate-setting process and replacing it with a new, independent, and formally regulated administrator

• Cutting more than 100 reference rates related to currencies and maturities for which there is insufficient trading

• Mandating that transactions be recorded and that submitting banks be regularly and independently audited

• Making the submission of false information by lenders that contribute to the Libor process a criminal offense.

Regulators are still questioning approximately a dozen of the world's biggest banks about their possible involvement in Libor's rate-rigging scandal. An article in the Economist, “The Libor Scandal: The Rotten Heart of Finance,” summed it up well: “the real obstacle to change is not a lack of good ideas, but a lack of will by the banks involved to overturn a system that has served most of them rather well” (Jul. 7, 2012, www.economist.com/node/21558281).

Supporters of U.S. banking deregulation should take note of FSA Managing Director Martin Wheatley's comments regarding Libor: “This problem has been exacerbated by a lack of regulation and a comprehensive mechanism to punish those who manipulate the system” (http://www.bloomberg.com/news/2012-12-13/rigged-libor-with-police-nearby-shows-flaw-of-light-touch.html).

How many more scandals will it take to teach us that deregulation is a certain path to destroying the public's trust in our global financial system?

As always, I welcome your comments.