Libor myopia risks missing the big picture of regulatory failure
PRICES keep markets sane. The information they provide connects the decisions made by traders, investors and managers to reality. Markets become delusional, and can fail spectacularly, when those price signals are interfered with and distorted. What we have sadly learned with the recent scandal at Barclays, and other major banks, is that the distorted price signals were not just the result of faulty regulations, but also the manipulation of the key Libor rate by participants in that market.
But the Libor scandal is being mistakenly linked to a myth – bought into by too many sage commentators – that the financial crisis was the result of too little regulation.
In recent years, there have been no shortage of rules. Europe Economics estimated in June 2003 that the median cost of FSA regulations alone were 1.6 per cent of non-regulatory operating costs. The problem, and people did point this out before the crisis, was that the authorities were too focused on ticking boxes – “producing and processing risk analyses and checklists” as Jon Moulton, founder of Better Capital, put it – rather than seriously addressing systemic risk.
Meanwhile, the international regulations that were supposed to control systemic risk were making things worse, not better. They were further distorting those price signals that should have been keeping the economy sane. By applying a very similar risk assessment framework across a broad range of institutions, the Basel II banking regulations encouraged financial institutions to hold a similar set of assets and respond in a similar way during a crisis. They created a financial monoculture, which showed its fragility when a bubble in the property market collapsed. This happened again when supposedly safe sovereign debt started to look very risky.
And that wasn’t the only problem. In 2004 a study for the Board of Governors of the US Federal Reserve System warned that those Basel II banking regulations would be procyclical as they would ease when the economy grew – and borrowers were less likely to default – allowing an asset bubble to develop. By contrast, in a recession they would tighten severely as the economy contracted and defaults became more likely. Those warnings have been vindicated. Despite claims the problem has been dealt with, the new Basel III regulations may still bear those fatal flaws.
Other interference in financial markets included support for the mortgage market in the United States by politicians with the understandable desire to increase home ownership. 44 per cent of all subprime securities were bought up by the government-backed Fannie Mae and Freddie Mac.
Even more fundamental than that were the low interest rates that formed a key part of the US response to a number of economic crises, like the housing crisis in 1992 and the end of the dot-com bubble in 2001. Those low interest rates encouraged both more borrowing and riskier lending. They were, in turn, legitimised by low inflation, thanks to falling prices for consumer goods. Many of those consumer goods were imported from countries that could export at lower prices partly due to manipulation of their exchange rates.
Finally, and most importantly, the sense that banks were too big to fail – vindicated by the actions of governments during the crisis – encouraged them to take risks in the expectation that the taxpayers’ chequebook would be put at their disposal if things went wrong. That will only end when there are clear plans to wind up bust banks, protect depositors’ access to their money and bail-in those who earned a fair return for the limited but real risk they would lose money by lending to mortal institutions.
All that is the context in which we need to understand the Libor scandal. We should also be criticising the politicians and regulators who made a mess of the financial system. Those mistakes ended the stability in the City that had lasted through a century of wars and depressions, with no serious deposit bank failures before this crisis since 1878.
The Libor scandal will make it easier for politicians to cast the problem as the greed of bankers rather than the failures of institutions. We need to look again at the other interferences with financial markets which, while much better intentioned, were often more dangerous.
Matthew Sinclair is director of the Taxpayers’ Alliance.