![A man walks by the headquarter of Standard Chartered bank in the City of London, Tuesday, Aug. 7, 2012. (AP Photo/Sang Tan) A man walks by the headquarter of Standard Chartered bank in the City of London, Tuesday, Aug. 7, 2012. (AP Photo/Sang Tan)](https://www.mintpress.net/wp-content/uploads/2012/08/Britain-Standard-Char_Webf-690x388.jpg)
That regulation of business is an evil drag on the freedom of business leaders to innovate and grow is a commonplace of right-wing rhetoric. Mitt Romney’s official website lists “regulation” as an issue all by itself and describes it as a “major part of the problem” of our “faltering economy.” The Web page cites a Small Business Administration estimate that regulations cost the economy $1.75 trillion a year.
Full assessment of that SBA report (to be accurate: done under contract for the SBA, not by the SBA), is a subject for another day. The $1.75 trillion estimate has been repeated widely, but also vigorously attacked by the Center for Progressive Reform. Whatever the dubious merits of this estimate, it was not created by adding up the cost of individual regulations and it does not assess the benefits of government regulations.
However, regulations are essential. The argument is usually framed in terms of an assumed trade-off between business profits and social benefits such as environmental and safety concerns. Romney, for example, attacks the EPA’s “war on carbon dioxide.” However, what is less often noted is that regulation of business is essential for business to function. The current scandal over LIBOR provides a good example of this.
LIBOR
LIBOR stands for the London Interbank Offered Rate. The deposits and withdrawals from banks seldom, if ever, match each day. As a result, banks need to loan each other money on a daily basis. There is a LIBOR for other currencies (such as Euribor for trades in Euros) and LIBOR rates for different terms of loans from a day to months.
LIBOR first came to the attention of a wider public during the first wave of the financial crisis in 2008. As a credit crunch developed, LIBOR started to increase above other interest rates. That showed that banks were becoming reluctant to loan to each other. Banks were hanging on to their cash and demanding more in interest if they were to loan out their cash. As the credit crunch eased, the difference between LIBOR and other interest rates dropped back down.
LIBOR has become one of a number of “neutral” interest rates, a kind of barometer or index of the state of the financial markets. Over the course of a business cycle, as interest rates go up and down, LIBOR will track that. As a result, LIBOR is used as the basis of many other rate calculations. Adjustable rate mortgages, for example, are often tied to either the interest rate on U.S. Treasury Notes or to LIBOR. The mortgage contract will specify that your interest rate will be (for example) 1.5 percent above a particular LIBOR rate. The value of financial instruments of all types tied to LIBOR as been estimated at a mammoth $360 trillion.
If LIBOR was an objective, neutral measure of interest being charged in the economy, this might work well. Indexing contracts to LIBOR would protect both seller and buyer against future changes in interest rates. However, LIBOR is not a well-regulated measure. And since 2007, a series of crises in LIBOR have shown exactly why government regulations are essential.
Counting and estimating
LIBOR is not a count of actual transactions; it is an estimate of what banks would be willing to do. It is, in fact, survey of intentions. According to the British Bankers Association, the trade association responsible for publishing LIBOR, each day a sample of large banks are asked, “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 a.m.?”
Expectations are not reality. A bank’s well thought out estimate might be wrong. Or a bank might expect to borrow, but decide not to do so. When the credit market gets tight, the volume of actual transactions shrinks, perhaps almost disappears, making the LIBOR an estimate of something that may not even be an active market.
Most of the time, this difference between expectations and actual transactions is not very significant. But in 2012 what came to light was a much more serious problem.
Manipulating expectations
If someone asks you what you actually did pay for something, you tell the truth, generally – and someone can always check on you to see if you were truthful. But if someone asks you what you expect to pay, you might well adjust your answer by what you hope to pay or be influenced by what you would gain or lose by paying more or less. This adjusting might be unconscious. Or it might be intentional.
The rate of interest you have to pay to borrow money is a function of your financial status. The stronger you are and the more likely you are to pay back a loan, the lower the interest you have to pay. As concerns mounted over the ability of countries like Greece or Spain to pay back their debts, the interest they were charged to borrow sky rocked. The fact that the interest rate on U.S. Treasury bills is so low is sign of the confidence people have that the U.S. government is not going to default.
A bank offering to pay more to borrow money, or being forced to pay more, could be seen as weak. Thus the temptation arises to shade their estimate of LIBOR just a little on the low side to avoid giving the impression that the bank is in trouble. Doing this doesn’t have to be malicious or even conscious. Or one bank might do it out of self defense because it becomes assumed that “everyone is doing it.” This practice of shading LIBOR estimates to avoid appearing weak has been going on for years, and banking regulators were, to some extent, aware of it.
Fraud
One aspect of modern financial markets is the extent to which you can invest in things that are not concrete products. You can invest in anticipated changes in the future value of shares, of commodities, the value of currencies, among other things. And, crucially, you can make bets on the future value of interest rates, including LIBOR.
Here is the problem: The same bank – or people who are friends with the bank – who make an estimate of LIBOR, will give you investment advice on which way to bet on the future value of LIBOR. More than that, a division of the same bank which make estimates of LIBOR will now be investing its own money in bets about the future value of LIBOR.
This is called “conflict of interest” and there is a long, long history proving that conflict of interest leads to problems. And LIBOR proved no exception.
Trader: “Coffees will be coming your way, either way, just to say thank you for your help in the past few weeks.”
Submitter: “Done … for you big boy.”
That exchange captures something you almost never get a chance to observe: the act of corruption and the bribe being paid in exchange for it. That was one of a long series of emails between traders at Barclays Bank and those who submitted the estimate for LIBOR. Over a period of years, Barclays had adjusted its estimate of LIBOR to assist its derivative traders in making money, a report by the British Financial Services Authority indicated. Barclays’ actions cost it a $450 million fine.
The FSA found that this problem was not a rogue trader or a few bad apples, it was systemic: “Senior management’s concerns in turn resulted in instructions being given by less senior managers at Barclays to reduce LIBOR submissions in order to avoid negative media comment.”
The value of a referee
While pointing to a specific act of corruption is dramatic and makes good copy, the real point here is that people should not be put in positions where their interests conflict. And a system where conflict of interest is deeply embedded will not work impartially for the interests of all. It doesn’t matter if the people in the system are gangsters or saints, conflict of interest leads to bad decisions.
Thus the need for regulation. The government has a role to play in a capitalist economy, and that role is the role of the referee. In this case, an interest rate that is used to decide the interest to be paid on a vast set of financial transactions needs to be regulated by people whose salary and job performance will not be affected if that interest rate goes up or down.
LIBOR isn’t just used for mortgages. It is essential to a series of contracts between business people. Quoting the FSA report, “The integrity of benchmark reference rates such as LIBOR and EURIBOR is therefore of fundamental importance to both U.K. and international financial markets.” Business needs this; it is essential to the smooth, and profitable, running of financial markets.
A neutral referee with the power to enforce the rules is needed so that honest business people are not put at a disadvantage. A referee not paid directly by the players and who can’t be fired by the players. And that, in a capitalist system, is the government.