To the man with a hammer…every problem is a nail

This week a major scandal came to light with regard to the setting of LIBOR, which is the interest rate at which banks lend to each other. It would appear that this rate, which is a useful index of short-term interest rates by which interest rates on other contracts (including mortgages) are set, was manipulated by traders in a particular financial institution. Presumably this was done for their own gain – at the expense of others who were counterparties to the contracts.

There have been the predictable calls for regulation. The French have said that this is a problem of rampant Anglo-Saxon capitalism which needs regulating – ignoring the fact that euribor uses a more or less identical system. Mark Hoban – the relevant government minister – has said both that this is a moral problem and that LIBOR should be regulated. Others have said that the problem is that we have nationalised central banks setting interest rates. Still elsewhere, it has been suggested that the problem is that we have a banking cartel and we need more competition.

The latter two positions have been taken by respected free-market commentators, but I don’t think they are correct. Certainly, central banks distort LIBOR. They do this both because they determine very-short-term interest rates which feed into LIBOR indirectly and also because they try to smooth liquidity in the market. However, even if central banks did not do this, there would probably be a need for something like LIBOR as a base interest rate that is used to set interest rates on other financial transactions. In fact, LIBOR is a very useful market instrument because it means that banks can lend to and take deposits from customers at a rate which is always related to an objective and transparent market interest rate. Customers can be sure that they will not get taken for a ride. At the same time, the bank will know that it can always get funding for or make deposits at roughly that rate. Without LIBOR long-term, floating-rate mortgages would be that much more risky.

The bank cartel argument is also something of a red herring. Yes, it is true that the smaller the number of banks, the easier it is to manipulate the rate, but there are 16 banks on the sterling LIBOR panel, so the cartel argument is stretching things somewhat.

However, the main threat comes from those who only have the regulatory hammer and think that regulation is the only solution to any problem.

Older readers of the blog may remember the Maxwell scandal. This was a case of theft from a pension fund. Not surprisingly, theft of hundreds of millions of pounds is illegal. But, the government thought that, rather than making some simple changes to primary legislation to make theft less likely (for example, by having more independent trustees within pension funds), they would regulate defined-benefit pension schemes. Older readers of this blog might also remember private-sector, defined-benefit pension schemes. Younger readers cannot join them anymore because the regulation hammer (and some other factors) led to the vast majority closing down.

We must be careful with regard to the LIBOR scandal. The British Bankers Association (BBA) is, in a sense, a private regulator for LIBOR and the government seems to be using this as an excuse for castigating the private sector and bringing in government regulation. However, private regulation has an excellent history, and government regulation certainly has not proven itself superior in the financial sector. We should resist arguments for more government regulation of LIBOR: neither government nor private regulation can bring about perfection. But we also need to point out any disingenuous statements from the proponents of government regulators given that the BBA states: ‘As all contributor banks are regulated, they are responsible to their [government] regulators, rather than BBA LIBOR Ltd. or the FX&MM Committee, for maintaining appropriate procedures for contributing, including the maintenance of internal chinese walls.’

But, surely, the main problem is not regulation in any case. Given Britain’s strict libel laws, I need to tread carefully. However, if what has happened is not fraud (and it is not being prosecuted as such at the moment) it ought to be. We do not need a specific government financial regulator to prosecute fraud and theft.

Secondly, as the minister has said, there is a moral and cultural issue here. Regulation is the wrong tool to deal with moral and cultural issues.

We have a confused regulatory system here. Instead of blaming private regulation we should perhaps go the whole hog and remove government regulation from the picture. LIBOR is a private arrangement and the banks that set it have the strongest incentives to keep it honest. The government should stick to prosecuting fraud. The private sector institutions that have an interest in LIBOR should club together and make sure that they impose the strongest possible penalties on those that disobey the letter or the spirit of the LIBOR regulations set by the BBA. Something like ‘my word is my bond’ would be a good start and, if someone’s word proves not to be their bond then the sanctions – administered by the club itself – should be severe. Indeed, the market sanctions have been severe already. Barclays’ share price is down 15 per cent. We cannot expect perfection and to avoid all incidents within financial markets, but this seems like a good feedback mechanism to me.

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

2 thoughts on “To the man with a hammer…every problem is a nail”

  1. Posted 04/07/2012 at 08:17 | Permalink

    Agree Mr. Booth. Unfortunately I don’t see any change of direction in the short future and more regulation is certainly coming. Yet, regulation is the effect, the cause being the mentality, ideology attitude and culture of most of the political establishment, including regulators and central bankers supported by half of the country and which they want to inculcate in the other half. Sadly, very few individuals in the “establishment” seem to have different opinions.

    There is an old Japanese proverb related to hammers and nails that came to my mind when I read the title of your post: “The nail that sticks out gets hammered down”. Barclays has always been the nail and everyone in Westminster, the FSA and the BoE. Regulation (and culture and morality which are the politicians’ tools and shields to push through further regulation) attempts to ensure that every bank is the same, that no-one is going too far ahead or lagging behind, to secure uniformity for the phony sake of “common good” and “consumers’ protection”. Far from creating a level playing field where everyone plays by the same rules it dictates a uniform pre-approved pattern of behavior for everyone, and, if someone steps out, the FSA will be watching.

    Demoralizing indeed. Our constitutional and primary law framework is a joke nowadays. It is there, full of dust and spiderwebs, but no longer relevant. Financial regulation is undermining that constitutional framework, the separation of powers, the presumptions of innocence, and in essence, it is the tool for politicians to control the financial market. We live in a crony capitalist country, but not because bankers have politicians in their pocket with their fat cheques. Actually is the opposite: banks are becoming another arm of governments in their utopian strive. Regulation is the tool and the FSA is the judge and jury.

  2. Posted 04/07/2012 at 11:22 | Permalink

    I broadly agree with Dr Booth – the danger of this whole crisis is that more regulation will be introduced. However, I don’t concur with this part:
    “The bank cartel argument is also something of a red herring. Yes, it is true that the smaller the number of banks, the easier it is to manipulate the rate, but there are 16 banks on the sterling LIBOR panel, so the cartel argument is stretching things somewhat.”
    Surely, the critical factor is not the number of banks (16 seems small to me, but still) but the size of the banks. Barclays is able to wield huge influence as a result of its scale. Now, far from being one of these people who thinks ‘we’ ie the state needs to break up banks – how is the state to know what size banks should be? Moreover, the banks tried to break up by going bankrupt and the state stopped them. As we know, it was state intervention that caused the banks to become so large, to a great extent, in the first place. This takes us back to state intervention in the monetary/financial system and the problems it has caused – until this can be eliminated, behemoths of the Barclays scale will continue to dominate, rather than a multiplicitity of players who would be less susceptible to this kind of market manipulation. The roots of the LIBOR scandal, like the root of the financial crisis, lie in state intervention into the economy

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