The LIBOR scandal and reform agenda:Can we trust these rates again?

By: Calvin Benedict

The London Interbank Offered Rate (LIBOR) scandal burst into the media spotlight on June 27, 2012, exposing fraudulent actions by Barclays in relation to LIBOR rates. LIBOR is the primary benchmark for short term interest rates globally and is used as a basis for settlement of interest rate contracts on a number of the world’s major futures and options exchanges.[1] Its use also extends to a wide range of retail products, including mortgages and college loans, and is therefore seen as a barometer to measure the health of financial money markets. LIBOR has been hailed as “the world’s most important number”[2] and rightly so as it is estimated that the notional value of financial products linked to the benchmark is at least $300 billion.[3]

The LIBOR scandal has further fuelled the fear that the global financial system is a flawed edifice premised on institutional corruption and has been infamously branded by George Osborne, the Chancellor of the Exchequer, as “the epitaph to an age of irresponsibility”.[4] The scandal stems from banks submitting artificially high or low LIBOR quotes to profit from their trading positions[5], or to alleviate the market’s perceptions and concerns of their creditworthiness.[6] One academic has even facetiously remarked that perhaps LIBOR should be renamed to “LIE-BOR”.[7]

1.    LIBOR-Setting Process – Prior to Reforms

LIBOR was formulated and administered by the BBA, a trade association for the banking and financial services sector.[8] The BBA LIBOR Ltd, a subsidiary of the BBA, undertook the daily running of the operations of the benchmark.[9] Each day a consortium of panel banks would submit their LIBOR submissions based on the following question:[10]

“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 am [London time]?”

A separate entity, Thomson Reuters, collected the submissions of the panel banks and after they were checked and verified, published the final LIBOR calculation to the market.[11] Thomson Reuters employed a trimming process to calculate all LIBOR rates:[12] submissions were ranked numerically in descending order following which the highest and lowest 25 percent of submissions were excluded. The remaining contributions were then arithmetically averaged to produce a LIBOR rate for a given currency and maturity.

The LIBOR question was open-ended, allowing for substantial discretion due to the opaque judging process. There was, for example, no requirement for the submitted rates to be based on actual or transacted figures. This means banks were able to submit false or misleading submissions, which had the effect of manipulating LIBOR.

Some panel banks sought to exploit the embedded conflicts of interest stemming from their multifaceted roles as being a contributor to the LIBOR rate, user of the rate and participant in the financial markets. There were two prevailing forms of conflict of interest:[13]

Credit signalling effect: A panel bank’s daily LIBOR submissions may be interpreted by external parties as a representation of the creditworthiness of that particular bank. During periods of downturn and uncertainty in the markets, there is a strong incentive for panel banks to purposely lower submissions to create a facade that their relative creditworthiness is not negatively affected by wider market events.

Private economic incentives: Panel banks are both users and contributors to LIBOR and possess assets and liabilities with exposure to fluctuations in LIBOR. This encourages traders to manipulate LIBOR for the benefit of a particular trading exposure, as well as providing incentive for collusion among panel banks.

Although, it is arguably easy, especially in hindsight, to criticise the LIBOR-setting process, it should be emphasised that the ensuing damage to the financial system from the rate manipulation is more a result of human behaviour – and a lack of restraint – than the mere existence of a flawed process.  The concepts of ‘human behaviour’ as well as ‘culture’ are addressed further on.

2.    Reforming the LIBOR-Setting Process

As the global repercussions of the LIBOR scandal continue to unfold, heightened scrutiny must be placed on the integrity of financial benchmarks and their overarching principles. It comes as no surprise, then, that this year the International Organization of Securities Commissions (IOSCO) published “Principles for Financial Benchmarks: Final Report”[14], and the European Securities and Market Authority and the European Banking Authority jointly produced “Principles for Benchmark-Setting Processes in the EU”[15]. The IOSCO report touched upon the market trepidations in which lending rates are now viewed:[16]

“[Recent] investigations and enforcement actions raised concerns over the fragility of certain Benchmarks – in terms of both their integrity and their continuity of provision – that has the potential to undermine market confidence potentially harming both investors and the real economy”.

The first notable reform effort occurred in July 2012, when the Chancellor of the Exchequer commissioned Martin Wheatley, the current chief executive of the United Kingdom (UK) Financial Conduct Authority, to review the LIBOR-setting framework.[17] The report sets out a simple ten-point plan to reform LIBOR.[18] Among the proposed UK reforms were:[19]

1. The introduction of statutory regulation for administrating LIBOR submissions
2. The BBA should transfer the oversight of LIBOR to a new administrator.
3. Transaction data should be explicitly used to corroborate LIBOR submissions.
4. The BBA should cease both compilation and publication of LIBOR for currencies and maturities for which there is insufficient data to corroborate submissions.
5. The UK authorities should closely cooperate with the European and international community by contributing to the debate of the long-term future of LIBOR and other global benchmarks.

This year has seen a major shift in the regulation and methodology used to calculate LIBOR. As of November 2013:

1. Individual bank submissions for LIBOR rates, as of July, are published only after a period of three months.[20] This is intended to mitigate the potential for manipulation and any reputational effects resulting from a bank’s submissions
2. LIBOR is now quoted for only five currencies and seven maturities.[21] Prior to this, LIBOR was produced for 10 currencies with 15 different maturities quoted for each currency, ranging from overnight to twelve months.[22]
3. The administration of LIBOR has become a regulated activity under the purview of the UK Financial Services and Markets Act 2000.[23]
4. The BBA LIBOR Ltd established the Interim LIBOR Oversight Committee (ILOC).[24] The two entities are collaborating to elicit views on “on the proposed introduction of intraday re-fixing” for LIBOR, which is scheduled to be published by December 31, 2013.[25] This forum for discussion is more centred towards dealing with genuine inaccuracies in submissions, say, whether published LIBOR rates should be rounded to 3 decimal places, instead of the current five decimal places, to minimise errors.[26]
5. NYSE Euronext Rate Administration Limited has been nominated to act as the new LIBOR administrator from early 2014.[27] The new administrator was acquired by IntercontinentalExchange Group, Inc. (ICE) – a global operator of futures exchanges and over the counter derivatives trading platforms.[28]
6. Amendments were introduced into the UK Financial Services Act 2012 to specifically make LIBOR manipulation a criminal offence.[29]
7. Draft legislation in the European Union has been proposed to ensure all benchmark administrators are authorised and supervised.[30]

Some concerns have been expressed regarding the potential conflicts of interest that may arise for ICE in its dual capacity as both a benchmark administrator and a commodities exchange. The perceived conflict of interest points towards another sound note of caution: piecemeal reforms aimed at enhancing the market’s integrity and encouraging swift enforcement can often be painstakingly difficult to put into practice, sometimes lacking a coherent modus operandi.

3.    LIBOR as a benchmark in the aftermath of the scandal

Change is certainly afoot. But the lack of international cohesion on the future of LIBOR is exacerbating an already difficult situation. We are once again, as with the Global Financial Crisis (GFC), being drawn into a globalisation debate of how to apply differing nationalistic thinking on an international scale.

It appears that the prevailing view in the United States (US) is that LIBOR should promptly cease to exist as a benchmark. Gary Gensler, the chairman of the US Commodity Futures Trading Commission, who is credited for leading the LIBOR enforcement action, has called for a new benchmark that is based on real data to replace LIBOR.[31] The Financial Stability Oversight Council, a collection of US regulators, have supported Gensler’s proposal[32] , with the transaction-based GCF Repo index being viewed as a viable alternative[33].

On the other hand, Martin Wheatley has advocated for a dual-track system i.e. a survey of panel banks should be conducted daily, along with a transaction-based rate until a full overhaul of the system can be enacted.[34] This should, from a theoretically viewpoint, reduce the market inertia attached to LIBOR-linked contracts that are already set to last for several decades. Wheatley additionally states that the market should, in fact, determine the future usage of LIBOR.[35] The new LIBOR administrator has also declared that dropping the quote-based LIBOR in favour of an index that is based on actual market trades will not happen anytime soon.[36] The rationale behind this, purportedly, is that a market-based index could prove troublesome when there are no (or very few) transactions.

It is clear from the foregoing that the pursuit for global consensus on LIBOR continues and we will, perhaps, only know the actual future of the benchmark in months to come.

4.    Has the original problem been solved?

While the reforms to the LIBOR-setting process convey a stricter, more intrusive approach to the regulation of the benchmark, the question remains: has the problem of wider market manipulation and abuse (and, of course, on a more parochial level benchmark rigging) been addressed and, to some extent, mitigated? This is, in essence, the heart of the issue. To reiterate, it was human behaviour, aided by a defective rate-setting process, which made LIBOR manipulation such a pervasive practice among banks.

The finance industry – and the banking industry in particular – is indispensible for the functioning of global markets. It facilitates the transfer of funds between savers, borrowers, and investors; it allocates capital, provides payment services, and allows risk mitigation through insurance products. The effectiveness of these functions is largely dependent on the integrity of those who operate in the industry; integrity which in turn gains trust. There is no doubt that the LIBOR scandal has undermined an already low public trust[37] in the finance industry and further rubberstamped the populist portrayal of bankers, who operate on the ideology that ‘greed is good’.

Trust generates market confidence and according to Stephen M.R. Covey, an influential American writer, it is a function of two features: character and competence.[38] Character includes one’s integrity, motives and intent whereas competency deals with capabilities, skills and results.[39] The proposed reforms to the LIBOR-setting process set out in “The Wheatley Review of LIBOR: final report”[40] centre on a more regulatory interventionist approach. These reforms offer a pragmatic value by improving the competence of regulators but do not touch upon the character feature of trust. It is imperative, therefore, that regulatory authorities have a steadfast and unwavering aspiration to promote market integrity by appropriately dealing with all allegations of market manipulation and abuse.  This is vital given the instrumental role that the finance industry plays in world economies.

However, the crux of the problem is that enhanced regulations and enforcement are by no means a panacea to the LIBOR scandal. Whenever a financial scandal arises the solution, as is the case here, is usually to give regulators more laws to enforce and the general assumption is that the problem has been addressed. This, however, ignores the fact that the regulators did not effectively enforce the old laws in the first place. The problem is that financial scandals keep arising, which questions the efficacy of interventionist reforms as a solitary vehicle for change.

4.1 Cultural Change

The LIBOR and other recent financial scandals cogently demonstrate that there are deeply rooted issues, which legal reforms alone will not appropriately address. Specifically, there must also be a cultural change within the finance industry. That is, a culture which engenders a meaningful and unified commitment to market integrity beyond window-dressing; emphasises the need for financial institutions to account for public interest in their decision-making; and ensures the sustainability of financial systems are not endangered by systemic fraud or manipulation. Leaders, top management and boards of financial institutions must realise that their actions have economy-wide consequences, and must therefore account for both shareholder value and wider public interest.[41]

In terms of a rotten apple versus rotten barrel narrative, is the LIBOR scandal the culmination of a series of failures by traders, bank management and regulators or the consequence of underlying structural incentives and learned behaviour? At first blush, an argument for a change in culture favours the latter, but the former could merely be an external manifestation of the latter. The divergence between the two narratives can be explained using the concepts of incentives and motivation. In 1976, Jensen and Meckling wrote an article on agency theory (also known as incentive theory) proposing that the interests of principals and agents can be aligned through the establishment of incentives.[42]

In the case of financial regulation, the interests of market players and regulators are aligned through negative incentives enforced via civil and criminal channels. However, the use of incentives to solve agency dilemmas fails to rationalise perennial market activities such as non-profit organisations, where often no incentives are needed to align the interests of principals and agents. This mismatch between theory and reality saw the emergence of Frederick Herzberg’s motivation-hygiene theory.[43] Herzberg drew a palpable distinction between motivation and incentives:[44]

“Why is [incentive] not motivation? If I kick my dog (from the front or the back), he will move. And when I want him to move again, what must I do? I must kick him again. Similarly, I can charge a person’s battery, and then recharge it, and recharge it again. But it is only when one has a generator of one’s own that we can talk about motivation. One then needs no outside stimulation. One wants to do it”.

Thus, the true nature of motivation lies in someone doing something because they want to.

By all measures, Wheatley’s review favours the rotten apple narrative (as LIBOR is still to a certain extent considered a reliable benchmark) with reforms targeted towards incentivising banks to behave credibly. However, if we choose to accept the rotten barrel narrative, Wheatley’s proposed reforms will only incentivise banks to window-dress or technically comply, as there is no motivation or culture to act beyond this tokenism due to a loss in perceived competitiveness. Simply put, there is incentive to technically adhere to the provisions of the reforms but no motivation to incorporate the spirit in which the reforms were drafted. Viewed in this context, we are presented with another conundrum: how do we motivate market players to behave credibly, and more importantly how do our societal perceptions support or challenge the actions and ingrained cultures of financial institutions?

4.2 Quantitative versus Qualitative measures

Let us explore the concepts of incentives and motivation within the backdrop of metrics used to measure a firm’s performance and insights provided by the field of cognitive psychology. The cognitive processes, including emotions, used to make complex decisions are costly as they require the collecting and processing of information. American sociologist Herbert Simon termed this human dilemma as ‘bounded rationality’.[45] The world of finance is no different.

As a result of our cognitive limitations, we simplify decision-making by aggregating information. Financial statements and corporate announcements are conventional examples of this need for informational aggregation. Company stakeholders need some way to measure performance in a manner which is timely, costly and simple.  As such, quantitative measures dominate financial statements as they are seemingly verifiable and allow for comparison. Qualitative measures such as social responsibility, ethics or culture do not readily fit into this informational aggregation paradigm as they are subjective in nature. Moreover, they are difficult to compare, and thus their use is often restricted to an anecdotal setting.

Due to these constraints, a firm is largely judged in performance by its ability to deliver current and future profits. Along similar lines, at an employee-level, the ability to deliver monetary returns is directly correlated with success and greater promotions. There seems to be no positive reward for qualitative measures such as ethics, and legal frameworks only seem to incentivise firms to do the bare minimum in terms of compliance. As a corollary to the preceding point, it is worth noting that ethics, much like the law, cannot be viewed in a purely philosophical vacuum. There is a balance to be struck between ethics and contemporary commercial reality. Professor Roger McCormick aptly observes this through the lens of the herd instinct phenomenon:[46]

“Banks compare their financial performance with their competitors. Their shareholders make the same comparison. If one bank refuses to accept the risky deals (or exotic balance sheet devices) being engaged in by others and as a result is out of line –and is not making as much money for shareholders – its management comes under pressure… there is in fact a strong incentive to conform. Further, behaviour which might at the outset look to be an ‘aggressive’ gaming of the system, over time, often becomes regarded as acceptable, even ‘standard market practice’”.

The fact that the LIBOR scandal has assumed such global significance involving several banks is somewhat a perverse validation of the herd instinct. Post-GFC, we as a society have repeatedly called for more ethical behaviour among financial institutions, yet at the same time continue to measure their performance and share price almost solely on profitability. We conveniently (or to our detriment, inconveniently) tend to ignore environmental, social and governance issues unless they can be quantified, for instance, through legal and regulatory settlements. There is a resounding inconsistency in this approach and an omnipresent danger: market players may seek – if they have not already – to adopt techniques such as regulatory and ratings arbitrage to avoid unfavourable laws in order to claim that they are legally compliant in ‘form’; although in ‘substance’ this may certainly prove to be untrue. The resulting situation is one where an action may be legally engineered to be compliant but still be ethically repugnant by any objective standard. This brings up another ancillary, albeit significant issue: how do we reconcile the societal desire of financial institutions to produce both a (quantitative) financial and (qualitative) social return?

Gigerenzer studied the relationship between bounded rationality and moral behaviour and presented two key findings on evidence amassed by social psychologists:[47] first, moral behaviour is determined by both mental states (such as character, moral reasoning and intuition) and the structure of social environments. Secondly, to improve moral behaviour towards a given end, altering the exogenous environment rather than changing internal beliefs tends to be more successful.[48] It stands to reason that for the finance industry to place greater emphasis on broader public interest, the best way forward may be through stakeholder activism that shapes wider political and economic landscapes. In its broadest terms, stakeholder activism refers to any person, group or organisation (PGO) that aims to influence behaviour.[49]

4.3 Stakeholder Activism

The business model of charities, targeted at providing a social return on investment (SRIO)[50], may provide fertile ground for greater discussion. Here, stakeholder activism is essential; a charity is only as effective as its employees, volunteers, sponsors and patrons. Using stakeholder activism to deliver a SROI is most effective when people are motivated and willing to dedicate their time to a cause they believe in.

The stakeholders of financial regulation and policy – including regulators, policy makers, think tanks, governments, non-governmental organisations, financial institutions, academics, and ad hoc groups of consumers and citizens – must act collectively on a transnational level to push for a cultural change. Stakeholders can ameliorate the shortcomings of international financial architecture by fostering a culture that changes the view, within the finance industry and on a societal level, of what is deemed as appropriate behaviour.[51] And while this might lead to a regulatory overhaul, this ipso facto should not be seen as a primary catalyst for change to transpire. Stakeholders can achieve their intended objectives by using both positive and negative publicity to influence the reputation of market players to such a degree that they eventually modify their actions.[52] In particular, finance professionals can affect the reputation of their firms through disclosure mechanisms such as whistleblowing.

Indeed, history is replete with countless examples of major advances made by stakeholder activism on environmental and social issues. The Occupy Movement, at one level, represented a societal progression towards stakeholder activism in order to attain a greater sense of morality among politicians and bankers. Regardless of one’s views toward the movement, its slogan “We are the 99%” did in fact raise awareness of socioeconomic inequalities insofar that it shaped the focus of political debates globally.  This, naturally, raises another set of questions: How do stakeholders reach a consensus on polemical issues and actively engage on a global scale to effect real change? Will stakeholder activism prevent further financial crises and scandals? There are, unfortunately, no easy answers to these questions. Nonetheless, even as a base incentive, if we do not collectively act, we will collectively lose – as the costs of bail-out measures needed to prevent the failure of systematically important financial institutions are borne by society as a whole. Ultimately, however, the future of the finance industry will fall on how motivated stakeholders are to create a workable symbiosis between economic, legal and social spheres. Meaningful engagements by stakeholders across public and political factions, concomitantly with resolute resolve by finance professionals towards a cultural change and a credible enforcement threat, are all essential stimuli for the long-term sustainability of world economies.

5.    Conclusion

The LIBOR scandal has signalled a massive breakdown in the trust of the finance industry as a whole. Without effective change and global cohesion, the status of fundamentally integral benchmarks like LIBOR will be continually eroded. The objective of this article has not been merely to critique and analyse changes to the LIBOR-setting process. Rather it seeks to reinforce that market players and regulators must not lose sight of the post-GFC raison d’être of financial policy and regulation, which is to restore public trust and market confidence.

In his candid analysis, Professor Justin O’Brien opined that the LIBOR scandal was tantamount to a systematic collapse:[53]

“The identified internal problems, failure of external supervision and now failure of enforcement paint a depressing picture… The rapid expansion of financial services has disproportionately benefited the industry itself, a process aided by defective internal and external supervision… William McDonough says a system booby trapped with an accelerant of incendiary toxicity is inherently dangerous. It can explode at any time. And it just has.”

O’Brien’s words are clearly warranted. At its core, the scandal highlights a cultural and ethical malaise that made compliance effectively redundant. Sweeping legislation and other legal reforms designed to curb LIBOR manipulation will prove ineffective if they are not supported by a swift enforcement threat and a change of culture in the finance industry. Legal reforms will always have their limitations as it is impossible to account for every contingency, and this is where stakeholder activism can – depending on the underlying incentives and motivations – become a prominent feature to align the need for a change in culture with broader public interest and long-term stability.