What began with a scandal that brought down the management of the venerable British bank Barclays is rapidly escalating. Barclays traders attempted to manipulate an obscure benchmark for global interest rates known as LIBOR, and it is now evident that Barclays was far from alone in its behavior.
But before this scandal train has completely left the station, we should be clear about what exactly is at issue. This is only partly about bad behavior by banks; it is equally about bad decisions by countless institutions that now want to avoid responsibility. The city of Baltimore filed suit this week alleging that the actions of Barclays and other banks cost the city dearly. Said the city comptroller, “The injury we suffered during the time we suffered it hurt more because we were challenged budgetarily…. Every dollar we lost due to illegal conduct was a dollar we couldn’t pay to keep open recreation centers or to pay police officers.”
The immediate response to such claims has been to accept them at face value and to jump on the bandwagon of evil banks doing yet more harm. Yet the claims of municipalities and pension funds—to be followed by thousands of individuals in multiple class-action lawsuits—are not to be taken as proof of harm. The behavior of banks well before 2008 and the financial crisis and in the years after has been egregiously self-serving and dangerously myopic about the connection between a healthy, lower-risk financial system and a healthy, thriving economy. That does not make the claims of harm, at least as stated, valid.
First, LIBOR is a rate set by a consortium of banks that voluntarily provide information to each other about the rate they are being charged by other banks. That fact that these banks were frequently dishonest about what they reported to each other has always been known, and even Sheila Bair, hardly an apologist for the industry, acknowledges that LIBOR has always, always had a significant “fudge” factor. LIBOR is the very definition of a rate set by a cabal, ripe for collusion. If various members of that cabal attempted to mislead other members for their own advantage, that may be a moral failing, unethical, and fraudulent. But the harm it caused is much harder to assess. Purposely reporting lower rates, as Barclays did, may have helped many customers even as it harmed others.
But the allegation is that banks manipulated the rate to the consistent disadvantage of customers. There are several issues with that assertion. People and individuals take on debt based on the interest rate they can obtain and on the amount of credit banks are willing to extend. Given that LIBOR (and its European cousin, EURIBOR) is a discretionary floating number based on the average of the reported rates of fewer than two dozen large banks, no institution, let alone any consumer, knows what the actual, real average would be if everyone reported faithfully. So the rate is, in effect, whatever the rate is. That then forms the basis of multiple lending contracts, from derivatives to mortgage rates.
But LIBOR is only the starting point. Credit ratings are much more influential, and banks charge far, far more than LIBOR. Current LIBOR rates are all under 75 basis point, or three-quarters of 1 percent. A year ago, they were all under 50 basis point, a half of 1 percent. But no one, other than banks borrowing from each other, borrows money at those rates. Mortgage rates are determined by a formula of risks involved, carrying costs to multiple players, and availability of credit, and are almost all in excess of 3 percent. And then there are credit cards, which go much higher. LIBOR is part of the determination, but only part.
For municipalities and pensions, the claim is that they purchased derivatives to insure against interest rate fluctuations on their outstanding debt, and that those contracts were directly tied to fluctuations in LIBOR. Hence, if that rate were distorted, they would lose more money or gain less money on those contracts. Baltimore says it had such contracts on about $550 million of the city’s bonds in 2008, on a budget in excess of $2 billion (in 2013 it is expected to be more than $3 billion). Baltimore, like countless cities across the nation, is experiencing severe shortfalls in expected revenue, pension obligations and ongoing expenses. Baltimore, also like countless cities, borrowed to close the gap between those expenses and revenues. And in its attempts to meet those obligations, it also bought complicated derivatives sold to it by banks. These didn’t behave as expected, but it is beyond a stretch to say that directly led to teachers and policemen losing their jobs.
In buying those contracts, there was no limitation on how much the banks that sold them might profit from the sale, nor were there any guarantees about how much they might be worth. But rather than adopting a “buyer beware” approach, it would appear that many institutions, looking for ways to avoid driving off the fiscal cliffs they were approaching, invested in financial products that they didn’t fully understand on assumptions that were at best naïve.
What this scandal exposes is that governments, pensions, and people were so hungry to avoid the mismatch between what they intended to spend and what they could possibly take in that they started purchasing financial instruments that they never should have bought in the first place. It also exposes a much more uncomfortable fact of today’s global financial system: There is no such thing as a globally-set, fixed transparent cost of money. Interest rates are set by central banks on one hand and by myriad free-market forces on the other. There is no global mechanism or regulation that prevents banks from charging whatever rates they can, save for multiple sovereign laws on excessive rates and usury. In short, banks may have colluded to “game” the interbank rate, but given that that rate is itself a product of interbank voluntary reporting, there is no clear and evident rate that is then specifically gamed.
Rather than adopting a “buyer beware” approach, many institutions invested in financial products they didn’t fully understand on assumptions that were at best naïve.
So what should be done? If we want there to be transparent, set rates that become the basis of all other rates, then it cannot be left to a voluntary cabal of large banks. This scandal may indeed lead to that. If we want a world where banks cause less systemic risk, then daily humdrum but absolutely vital activities like payrolls, small-business loans, deposit and checking accounts ought to be conducted by different banks than the ones trading derivatives and engaged in speculative activity. And if we want a world where banks do not play an outsized role in our collective health, we need to borrow less money to close gaps that are the result of an unbridgeable mismatch between future growth and current spending plans. Why should so many pensions and municipalities resort to derivatives to close those gaps and then blame banks when those strategies fail to do so?
Some have described the unfolding scandal as banks “tobacco moment,” drawing the analogy to the huge liability tobacco companies incurred for selling a deadly product and pretending it wasn’t. That may be an apt analogy, save for one vital lesson: in the end, reducing the deadliness of smoking wasn’t just about hobbling the tobacco companies; it was about people realizing that smoking is deadly. Many banks sell dangerous products to naïve customers. That will only truly end when those customers start making wiser choices.