Sometimes in life it feels sweet to say "I told you so”. This week is one such moment. Five long years ago, I first started trying to expose the darker underbelly of the Libor market, together with Financial Times colleagues such as Michael Mackenzie.
At the time, this sparked furious criticism from the British Bankers’ Association, as well as big banks such as Barclays; the word "scaremongering” was used. But now we know that, amid the blustering from the BBA, the reality was worse than we thought. As emails released by the UK Financial Services Authority show, some Barclays traders were engaged in a constant and pervasive attempt to rig the Libor market from 2006 on, with the encouragement of more senior managers. And the British bank may not have been alone.
No doubt some financiers would like to dismiss this as the work of a few rogue traders. And, in line with usual banking practice, the more junior authors of the incriminating emails have already been fired. But the wider symbolic significance of these revelations cannot be overstated; for they expose a big conceit at the very heart of the modern banking world.
Most notably, in recent decades large investment banks in the City of London and Wall Street have increasingly wrapped their activities with an evangelical adherence to the rhetoric of free markets; whenever they have wanted to justify sky-high profits, wacky innovations or, most recently, the need to prevent a new regulatory drive, they have invariably cited the ideals of Adam Smith.
But what the story of Libor shows is that this free market language has been honoured as much in the breach as the observance, to borrow Shakespeare’s phrase. And that was not just because a few Barclays traders were failing to "post honest prices”, as the emails admit. Instead, the real issue was that Libor was never organised as a proper market in the first place, which is precisely why the manipulation continued unchecked on such a wide scale for so long.
To understand this, think back to Smith’s own work. When the Scottish economist wrote his treatises more than three centuries ago, he lived in a world where business was dominated by small, family-owned firms. Smith took it for granted that in any market system the interests of owners and managers should be aligned, and these entities act within a wider social and moral framework. He also assumed two other ingredients should be in place: widespread, free participation in markets, and genuine price visibility. Without such open access, it is hard to have competition in a market economy, or the all-important ingredient of trust.
Many parts of the 21st century financial system display these attributes; public equity markets are (mostly) a case in point. However, in recent decades, the swaps sector has honoured these principles only patchily, at best. And in the case of Libor, the pricing was murky and capricious, since it was based on private reported quotes, not tangible deals. Moreover, the market has been dominated by a small clique of powerful banks, which also controlled the BBA. Owners of banks (ie shareholders) have had little chance of controlling the activities of these financial managers. Little wonder the group angrily brushed off criticisms in the past.
Reforming this system will not be easy. After all, one reason the BBA developed its peculiar price reporting system for Libor in the first place was that it was harder to use an open market system to set lending rates than trade equities. The task has become doubly difficult in recent years because parts of the interbank lending market have dried up.
And while some financial players are now trying to atone for this by turning to other benchmarks, such as the OIS, these are unlikely to replace Libor soon. After all, an estimated $350 trillion of derivatives contracts have already been written using Libor as a reference point, and about 90 per cent of US commercial and mortgage loans are thought to be linked to the index, too. That means that Libor – like credit ratings – is now hard-wired into the system, even with its flaws.
If nothing else, this week’s revelations show why it is right for British political figures, such as Alistair Darling, to call for a radical overhaul of the Libor system. They also show why British policy makers, and others, should not stop there. For the tale of Libor is not some rarity; on the contrary, there are plenty of other parts of the debt and derivatives world that remain opaque and clubby, and continue to breach those basic Smith principles – even as bank chief executives present themselves as champions of free markets. It is perhaps one of the great ironies and hypocrisies of our age; and a source of popular disgust that chief executives would now ignore at their peril.
Copyright The Financial Times 2012.