With the US Presidential season underway what little attention we pay to the mother country centers on the royal family, not a burgeoning scandal that could rock the entire financial world. A scandal that also once again calls into question the basic approach of Dodd-Frank, the US legislation designed to avoid the financial bubble at the heart of the 2008-2009 crisis. Essentially, the major banks of Britain manipulated the LIBOR interest rate. Why does that matter?
On a very simplistic level, LIBOR is the interest rate that banks charge each other to borrow money. At some time in the late 1990s LIBOR became the basic interest rate used as a benchmark in every contract I read as an executive. You might pay LIBOR plus 350 basis points (3.5%) for a bank loan or LIBOR plus 600 basis points on some riskier loan or LIBOR plus 150 basis points on secured receivables to finance a business’s cashflow fluctuation.
LIBOR was the benchmark for everything. It was the business constant meant to mimic the speed of light in physics. And at some point in the last few years it became false.
Every contract, every loan, every mortgage, every government contract, every everything that set pricing and terms off a benchmark rate used LIBOR. And it was all wrong. Traders in London banks manipulated the rate so they could make technical profits and boost up bank earnings, particularly when the investment banking and other risky sides of the banking business started failing.
Markets depend on certainty and transparency. People and business have to trust that regardless of the individual failings of banks, businesses, and people the market reveals fraud or negligence and allows investors and traders to sell those bad assets timely, not after a huge bubble has formed. We now know that the entire world basis for price and terms was fraudulent.
How can we trust the market?
Dodd-Frank and many of the reforms in the UK seek to regulate bankers. The reforms set up mandatory market mechanisms for derivative trading, dictate how banks will manage their other businesses, regulate pay, and other tactical reforms. But they do not get at the root cause of the issue.
Banks cannot be retail government insured depository institutions, uninsured investment banks, uninsured insurance companies, and partially insured brokerage houses. Time and again banks have shown they will use the sharpest minds in law, finance, and lobbying to create new products that skirt the reforms. And the motive for this behavior is that when the risky and highly profitable branches of the bank (investment banking for example) are down, the banks have got to make up a new way to generate earnings.
The only way to reform the banks is to reverse aspects of the 1990s banking reform at the structural level. You simply cannot mix banking business lines. If you do, you inevitably set up the incentives that lead to 2008-2009 and now LIBOR. The banks have to be broken up to some extent to avoid the inherent conflicts of interest and market impact of behemoth institutional failure.
Because at this point, no matter how cleverly regulated, how can you trust any bank or any contract?