What have major banks in the US and Europe done to deserve $250 billion in fines since 2009 plus the likelihood they will be forced to cough up an additional $72 billion by 2017? Let us count the ways:
- Money “laundering”
- “Fixing” foreign exchange rates
- Doing the same for money market and interest rate “swap” rates
- Originating and selling substandard residential mortgage loans to government agencies
- Helping wealthy clients avoid taxes
- Deceptive selling of financial insurance products to retail customers
In Part I of this series I discussed the high costs and ineffectiveness of money laundering laws in the US and elsewhere. In this blog I will examine the complex issues behind the massive fines imposed on banks and the criminal charges brought against traders for “fixing” foreign exchange, money market and interest rate swap rates.
How prices are set (especially the price of money) is probably the single most important determinant of how well an economy functions. As Friedrich Hayek put it in The Constitution of Liberty in 1960,
Because we rarely know which of us knows best, that we trust the independent and competitive efforts of many to induce the emergence [through marketplace pricing] of what we shall want when we see it.
What happens when marketplace pricing is widely repressed is well documented by the collapse of the Soviet Union and, presently, the on-going disintegration of Venezuela’s economy. However, the institutional framework within which pricing for any particular item takes place is never as simple as economists’ models would have you believe.
Price fixing. Lots of financial market prices are “fixed” in some sense. The most obvious case is end-of-day contract settlement prices on the futures and options exchanges. A select group of exchange traders and officials decide on what the prices will be for valuing everyone’s portfolio, even if some of the contracts haven’t traded during the day. Depending on the agreed rates, some traders’ accounts will receive cash and others will have to pay out.
Mutual funds are required to report portfolio gains and losses on a daily basis, and need to estimate end-of-day prices for individual securities. Sometimes municipal bond mutual fund managers, have played games to puff up the value of their portfolios. For years, money market fund managers have benefited from an artificial accounting pricing convention that reduces the volatility of their portfolios.
Central banks fix key short-term rates while trying to control long-term rates. US banks’ “prime” lending rate historically was set by a handful of the largest New York or Chicago banks who never bothered to detail their calculations. When Japanese banks invaded the US lending market in the 1970s and started taking market share from the established players, the basis for pricing loans to “prime” customers shifted to the “Federal funds” rate, directly controlled by the Federal Reserve.
LIBOR. The emergence of the Eurodollar market, beginning in the 1960’s, saw London emerge as the central marketplace in “off-shore” US dollars. That led to an agreement by the major banks to use the collective average rate they would pay (offer) for large deposits of various maturities in ten major currencies. Thus the acronym, LIBOR. It is used not only to set deposit rates, but also for loans, including some mortgages. In addition, the rates are used to “mark to market” the value of outstanding transactions, not just new ones - a matter of great interest to bank traders of securities and portfolio managers.
Originally administered by the British Banking Association, the rates are determined by polling a panel of banks at a specific time each working day. The average rate is then computed after eliminating the highest and lowest 4-5 banks’ quotations. Rates did not necessarily reflect actual transactions, since not all the panel banks undertake transactions in all currencies and maturities every day. The rates submitted by each bank were published simultaneously with the calculated LIBOR rates “to promote transparency and public accountability for the accuracy of submissions.”
The ability of a single bank to “fix” the calculation of LIBOR is clearly limited. An extremely high or low submission wouldn’t even figure in its calculation. However, the record is clear that individual banks submitted “off-market” rates at times. An unpublished paper by Snider and Youle and recent court testimony (see below) are persuasive.
Furthermore, there were efforts at times by a handful of traders and brokers to try collectively to “push” LIBOR in a particular direction. Of course, such activity, even if it had no impact on the final rate, is presumably illegal. However, I am not familiar with any studies or testimony that show those efforts were successful.
Most of the above comments also apply to the “ISDA fix” which is used to determine valuations and settlements in the multi-trillion dollar interest rate “swap” market. Barclay’s Bank, in particular, was aggressive in trying to “paint the tape” for the daily fix, sometimes in conjunction with its brokers.
“Low-balling” rates. The initial accusations regarding “fixing” LIBOR focused on banks submitting rates that were lower than what they actually had to pay for additional funds. In 2008, when the global financial panic was well underway, a bank which showed through its published LIBOR submissions that it had to “pay up” significantly more than its peers for new funds could spark concern that it was “in trouble.” This concern could out-weigh the lower income received on its floating rate LIBOR lending, at least in the short run.
There is good evidence that the Bank of England was well aware of this “stigma” issue and did not discourage at least one bank, Barclays, from adopting this subterfuge. Their submitted rates would be high enough to be thrown out of the calculation but not high enough to alarm customers. In other words, their submission had no impact on the calculation of LIBOR, whether or not they submitted an accurate borrowing rate. Another, less credible charge, is that the banks submitted “low-ball” rates at this time to drive down the cost of using a special Bank of England liquidity facility.
Targetting and high-balling rates. Traders with large positions in interest rate-sensitive securities, especially interest rate swaps, might lobby for a LIBOR or ISDA “fix” rate used to determine gains or losses on their activity – and bonuses. The rate might be higher or lower than the actual borrowing cost to their bank. This type of activity has been admitted by Tom Hayes, a former trader at UBS and Citigroup currently on trial in the United Kingdom and others. However, no evidence that they were successful has been published.
Attention sifted recently to evidence from British Bankers Association records of trader interviews that between 2005 and 2007 banks in LIBOR panels were deliberately over-stating their borrowing costs as a way to increase returns on their loan portfolios. Of course a portion of the earnings from any upwardly biased LIBOR loan rate would be lost in having to pay higher rates to LIBOR depositors.
“Fixing” the foreign exchange market.Regulatory authorities in the US and UK have fined major banks in the past two years over $9 billion for sins committed in their foreign exchange dealings. Their chief transgression was manipulation of the afternoon “fixes,” two daily benchmark rates based on actual transactions intended to make life easier for customers. The US Department of Justice also cited some of them for “deceptive trading and sales practices.”
A recent excellent article in The Financial Times explains why bank clients want a published benchmark and why banks try to protect themselves from an imbalance of pre-fix orders on the “buy” or “sell” side in a particular currency. Trading during the short fix period (one minute) left bank traders open to accusations they were trying to move the final price, or so-called “banging the close,” as was the case at times. (In other financial markets similar behavior is called “painting the tape.”)
As the former manager of a global foreign exchange group, I am familiar with a variety of practices intended to protect a bank’s own position in foreign exchange trading, and in trying to increase the profitability of trading with a customer. The “mark up” on a publicly available benchmark price is a matter of negotiation. There is no need for the Justice Department to act as the customer’s partner. Disgruntled clients who take their business elsewhere are the optimal enforcers of “fairness” in market transactions.
However, when banks collude to manipulate rates, that violates Hayek’s caution that we need “independent and competitive efforts” by market participants to arrive at a price that is “fair” and efficient in an economic sense. In this case, both the authorities and the injured private parties should properly sue, as in the case of the foreign exchange benchmark rates. (Bank customers alone have successfully sued for at least $900 million from five of the offenders.)
What’s the price? As the above discussion is intended to show, trying to determine what is a “fair” price is not a simple matter in financial markets where trading is a global, 24-hour-a-day activity in a multitude of currencies with a daily turnover of over $5 trillion in the foreign exchange market alone.
The processes for setting rate benchmarks have been altered over the past year. In the case of LIBOR, the administration has been taken out of the hands of the British Bankers Association and turned over to a subsidiary of Intercontinental Exchange, owner of the New York Stock Exchange and a wide variety of financial market places and clearing houses. Individual submissions will be published with a three month delay. The foreign exchange “fix” rates will continue to be administered by a subsidiary of State Street Bank, but the time period for collecting transaction data will be extended to five minutes from the previous one.
Designing manipulation-proof benchmarks is an extremely difficult task. Bank customers desire credible ”market” pricing. But pricing for individual customers understandably depends upon the size of the transaction, the creditworthiness of the customer, the overall business relationship, and the liquidity of the market at the time of the transaction.
The changes made to LIBOR and foreign exchange benchmarks will make manipulation more difficult. The massive fines levied by governments and settlements with aggrieved customers will temper, for a while, the continuing incentives to fix “the fix.” But the most powerful prescription for fair and efficient pricing in these – and any other – markets is alert customers and far-sighted managers.
The absence of these two players in sufficient number opened the door to the on-going saga of billion dollar fines for many of the world’s largest banks.