Featured Commentary - LIBOR - Neal Wolkoff, July 5, 2012
The LIBOR Scandal: Trying to Make Sense So Far
Neal Wolkoff is the CEO of Wolkoff Consulting Services, a New Jersey-based firm specializing in Dodd-Frank preparedness and other regulatory issues affecting the financial sector. He is a veteran exchange executive, having previously served as CEO of ELX Futures and the American Stock Exchange (AMEX), and as chief operating officer of NYMEX. His commentary appears frequently in MarketsReformWiki and the John Lothian Newsletter.
|Neal L. Wolkoff|
|Employer||Wolkoff Consulting Services|
|Location||South Orange, NJ|
The reports by the U.S. Department of Justice and the U.K. Financial Services Authority make clear that the LIBOR scandal that has so far engulfed Barclays and driven its top three executives from their offices involved two separate types of events over a period lasting about five years. The first category of violation started in 2005, and involved a game among traders to use their status as a member of the Committee who provided the LIBOR prices to the British Bankers Association to better their own interests. These traders, so far identified as Barclays employees and former employees who moved to other banks, used their influence in the LIBOR price setting mechanism to facilitate better "marks" so that LIBOR would be established at a more favorable level to their proprietary trading positions than would otherwise have been the case.
The second category of violation happened in conjunction with the financial meltdown. Starting in 2007 and continuing through 2009, traders sought to disguise the elevated interest rates that counterparties were demanding in order to loan funds on a short term basis to Barclays. If Barclays' borrowing rates were perceived as higher than Barclays' competitors, clients of the large dealer banks might conclude that Barclays was an unsafe - or at least less safe - credit risk, and would choose a competitor with which to do business.
The attempt at manipulation of LIBOR rates in the first category - i.e. helping the traders make money even when they were wrong about the LIBOR rate - could have affected LIBOR rates in either direction. Rates might have gone higher, thus increasing the costs to borrowers and consumers, or they may have been set lower than they should have, thus helping consumers and hurting the lenders whose lending costs were set on whatever the BBA determined LIBOR to be. Interestingly, the second category of attempted manipulation of LIBOR rates only helped borrowers and consumers at the expense of lenders who would be receiving less than true value in return for their loans.
The first category of falsified rate submissions occurred in the ordinary course of the trading day, and appeared to be perfectly acceptable to traders on the desk. The DOJ report quotes emails between two Barclays traders where the submission of false rates was discussed and agreed to:
As another example, on February 22, 2006, at approximately 9:42 a.m., Trader-1 sent an e-mail to another Barclays Dollar LIBOR submitter (“Submitter-2”) stating, “Hi (again) We’re getting killed on our 3m resets, we need them to be up this week before we roll out of our positions. Consensus for 3m today is 4.78 - 4.7825, it would be amazing if we could go for 4.79...Really appreciate ur help mate.” (ellipses in original). Submitter-2 responded, “Happy to help.”
Barclays has agreed to a large fine, so it is not a question of whether these conversations to establish fictional LIBOR rates to help a trading position actually occurred. The open question, and the one where other similar emails may or may not surface over the next few weeks or months, is whether traders who were not employed by Barclays also engaged in the same exchanges to help their own firms' trading strategies appear to be successful. The settlement documents indicate that conversations happened between Barclays traders, and also between current Barclays traders and former Barclays traders. What we don't know is if Barclays traders and unassociated traders working for other banks ever conspired, or if traders at other banks engaged in the same sort of comraderie that the Barclays traders had.
In many respects, the public harm from groups of traders agreeing to give false submissions to affect a major interest rate index is greater than the harm caused by anxious bankers looking to protect their image among customers and the public from other firms low-balling their LIBOR submissions. At least in the latter category, the public (borrower) was aided by lower interest rates resulting from the public image repair work taking place among the elite of interest rate traders. In the case of traders simply seeking to help their failed trading strategies look better than they were, lenders, borrowers and their firm, which compensated these traders based on performance results, were all harmed, and for no higher purpose than greed.
In 2007 and particularly in 2008 we see Barclays being slammed by the media, and likely by its competitors, for honestly submitting LIBOR rates reflecting the increased cost of borrowing when large banks were facing huge and opaque risks of loss. At the time, was Barclays the weakest bank? No, since Lehman and Bear were far weaker, as was Citi, RBS and Morgan Stanley. Goldman? Perhaps. The question that will presumably be answered - or at least asked - is why Barclays' rate submissions were higher than the submissions by its peers? If it was unlikely that Barclays' short term borrowing costs were higher than many of its competitor banks, why would Barclays have consistently been an outlier in LIBOR submissions to the BBA? The logical, but of course unproven, conclusion is that some or many of the other banks were lying about their cost of short term borrowing when submitting rates to the BBA. And it appears that like the SEC auditors who reviewed the Madoff trading records during the height of his Ponzi scheme, noone at the BBA sought to obtain the source records of the actual confirmed trades between the banks and their counterparties to confirm the accuracy of their LIBOR submissions.
It is also clear that Barclays put up quite a fuss to its regulators about the LIBOR marks that its competitors were submitting. According to the DOJ Statement of Facts:
During approximately November 2007 through approximately October 2008, certain employees at Barclays sometimes raised concerns with individuals at the BBA, the Financial Services Authority, the Bank of England, and the Federal Reserve Bank of New York concerning the diminished liquidity available in the market and their views that the Dollar LIBOR fixes were too low and did not accurately reflect the market. In some of those communications, those employees advised that all of the Contributor Panel banks, including Barclays, were contributing rates that were too low. Those employees attempted to find a solution that would allow Barclays to submit honest rates without standing out from other members of the Contributor Panel, and they expressed the view that Barclays could achieve that goal if other banks submitted honest rates. These communications, however, were not intended and were not understood as disclosures through which Barclays self-reported misconduct to authorities.
My all-time favorite exculpatory (rear-end covering) statement - one regulator to another - is that "These communications, however, were not intended and were not understood as disclosures through which Barclays self-reported misconduct to authorities."
However these statements were intended - as self-reporting misconduct or just reporting potential misconduct - Barclays was taking the highly unusual step to notify the key regulators in the U.K. and the U.S. that it believed that other banks were fudging the numbers, and that Barclays in response was also fudging the numbers. But, like the end of a scene in Waiting for Godot, the regulators did not move.
Later, we learn that Barclays' CEO Robert Diamond has a conversation with a senior regulator at the Bank of England about the LIBOR submissions by Barclays and by its competitors. As summarized in the FSA settlement:
However, as the substance of the telephone conversation was relayed down the chain of command at Barclays, a misunderstanding or miscommunication occurred. This meant that Barclays’ Submitters believed mistakenly that they were operating under an instruction from the Bank of England (as conveyed by senior management) to reduce Barclays’ LIBOR submissions.
According to a report in the Financial Times, the bank regulator in question, Paul Tucker, somewhat ambiguously - and entirely lamely - mewed to Mr. Diamond that “it did not always need to be the case that we appeared as high as we have recently”.
Whatever explanation may be put forth by the Bank of England, the FSA, the Federal Reserve, and the British Bankers Association, they all had knowledge that the integrity of the process by which LIBOR rates were being set was in severe doubt. Again, why would Barclays - perhaps not the strongest bank, but certainly not the weakest; a bank that was able to survive the financial crisis without a bailout - have higher borrowing costs than Citi or Morgan Stanley or RBS? Sometimes regulators take the view that they know how to calm or soothe the markets, and perhaps sometimes that is true. But, in this case, they used that belief to enter into at best a willful blindness about what they were being told, and what the numbers showed. The LIBOR rates were being fictionalized to hide the true financial condition of the banks from the public.
Of course, the fact that a regulator is being weak, silent, vacillating, and perhaps complicit, is not a justification for a leading financial institution to manipulate the LIBOR rate, even if its purpose is aligned with the regulators': to fictionalize the financial health of the banking system to avoid a public reaction to the truth. At the end of the day, as Ken Lewis learned after the Federal Reserve twisted his arm to buy Merrill Lynch, Bank of America's obligations for full disclosure under the U.S. Securities laws did not evaporate because of pressure coming from an important regulator. The Fed could not waive those obligations. The country does not enter martial law during times of financial crises. The rules are the rules, and even if the regulator wishes for the rules to all go away, only a fool believes that will happen when the dust settles. What role Barclays' compliance officials played in helping the bank slide down this hellhole seems clear from the reports: as self-regulators, they attended meetings, took notes and did not utter a peep.
The other shoe is about to fall, or not, but the Bank of England and the other financial regulators will not be the ones facing civil penalties and possible jail time. That will be left to the regulated firms and their employees who thought they had the best interests of the financial world at heart because the regulators did not tell them what to do or not do.