To many observers, the ongoing scandal surrounding Barclays PLC’s role in manipulating the London Interbank Offering Rate (LIBOR) may go down as one of the most significant and far reaching events associated with the global financial crisis.  This is for good reason: by most estimates, literally hundreds of trillions of dollars’ worth of global financial contracts – ranging from mortgages to credit cards to corporate debt securities to financial derivatives – hinge critically upon LIBOR to peg the financial obligations of the parties.  Indeed, nearly immediately after its creation over two decades ago, LIBOR began to fulfill the mandate adopted by its creator, the British Bankers Association: To become the “World’s most important number.”  The June 2012 action against Barclays – and the concomitant suggestion that Barclays may have been but the tip of the iceberg – has dramatically undercut the integrity of this key Archimedean point of financial contracting.

And yet, in a somewhat peculiar way, perhaps the most intriguing aspect of the LIBOR scandal is the fact that this summer’s revelation surprised virtually no one remotely familiar with the topic.  It was – in effect – an open secret; hiding in plain sight.

Indeed, in April of 2008, more than four years before the Barclays notice (and fully six months before the world’s financial markets and economies were thrown into a global tailspin), the Wall St. Journal published a prescient investigative study of LIBOR. The evident degree of misreporting suggested by the Journal was far from uniform, and varied widely by bank. One could certainly quibble with the Journal’s methodology (e.g., its reliance on credit default swap markets as a reliable external market measure of borrowing costs).  Nevertheless, most observers understood the Journal report for what it was:  A plausible and facially persuasive case that LIBOR was being manipulated as far back as 2008.  And consequently, much of the “shock” now being expressed by the Barclays case is substantially theatrical and performative, roughly akin both to Inspector Renault’s shocking discovery of gambling in Rick’s Café in the movie classic Casablanca, as well as the shocking revelations that Lance Armstrong may have benefitted from blood doping in winning his seven Tours de France.

But behind this regulatory performance, perhaps a more intriguing question is why this largely open secret remained uncorrected and unaddressed by banks and regulators for such a long period of time, particularly given LIBOR’s critical centrality in financial markets.  The ultimate answers to these questions are certain to prove complex, and many of the facts are still not known.  Nevertheless, we posit that a combination of incentives, hierarchies and organizational cultures likely contributed to the larger episode.  Due attention to those forces, moreover, will almost certainly be a prerequisite to the building of a better LIBOR (or LIBOR replacement) in the future.   In this opinion, we focus on three communities where these organizational cultures plausibly played a role:  The BBA, as the monopoly supplier to the “benchmark” market; the regulatory communities charged with oversight, and finally the reporting banks themselves.

The Market for LIBOR and the BBA Culture

On Sept. 13, 2012, top executives from the 25 BBA member banks — who together compose the BBA’s council — voted overwhelmingly to cede control of LIBOR, for which they have been the official coordinator since the benchmark’s inception. Until recently, its history had been one marked by tremendous success and growth.  In the mid 1980s, financial contracts generally lacked a unified benchmark rate to govern variable-rate and syndicated debt.  It had become clear by then, however, that the growing demand for such financial structures turned critically on the existence of a “common denominator” upon which to frame terms across and between borrowers and lenders.  Although its initial aims were targeted, LIBOR’s popularity soon outpaced its mandate, as growing market appetites for interest rate swaps, collateralized assets, credit derivative and risk management contracts – all facilitated by significant tax reforms in the late 1980s – also began to incorporate the benchmark.

By the turn of the 21^st Century, it had become clear that LIBOR was far more than a technocratic calibration device: through its popularity, it had become a commoditized “product” that could be bought, sold, purchased and licensed through the BBA.  The network effects of LIBOR’s widespread adoption had effectively transformed the measure into as much marketing pitch as it was a market metric.  This change, however, also introduced a shock to the incentive structure surrounding BBA’s own administration of the benchmark rate.  Under the new regime, the exposure of reporting problems could potentially undercut the BBA’s efforts to capitalize on (and appropriate rents from) LIBOR’s market dominance.  This realization, we posit, led to a growing commitment within the BBA organizational culture to refrain from casting doubt (at least publicly) on the integrity of the measure.   It is plausible to believe (and many involved in the discussions have implied) that the BBA made this choice largely to retain control of the revenue streams it was earning (and continues to earn) through LIBOR.

Regulatory Culture

A second important potential contributor to the culture of non-compliance concerns the nature and evolution of bank regulation itself.  Two important aspects of the regulatory landscape began to shift dramatically at the turn of the century.  The first was meta-regulatory:  as a result of the mega-merger between Citibank and Travelers Insurance in 1998 (and the repeal of the Glass-Steagall Act in the US less than twelve months hence), the 65-year old regulatory boundaries that had long separated commercial banks, investment banks, and insurance companies was fully dissolved.  A second interconnected shift was micro-regulatory: the problem of coordinating “multiple monitors”.  This regulatory oversight problem was perhaps most pronounced in areas where all areas of banking activity overlapped; and one of those areas was, in turn the fixing of benchmark rates that affected all aspects of the BHC’s operations.  (And, as we shall see below, even if the right hand of the regulatory state was not fully aware of the left hand’s actions, the same proposition did not hold within the BHCs themselves).

What followed was an odd one-two punch of regulatory collective action problems.  In the years preceding the financial crisis, most regulators (particularly those in the US) were preoccupied with offloading much of their oversight onto others, particularly as their targets for oversight became larger, more sophisticated and more complex.  In the months and years following the advent of the crisis, a different type of regulatory collective action problem arguably took hold: one of practical damage control, self-preservation and sporadic finger pointing through litigation. 

In the case of Barclays, those efforts may well have been animated by a certain measure of scapegoating.  It seems reasonably clear to all (or at least most) that in spite of all its likely missteps – and there many, to be sure – Barclays was nowhere near the worst abuser of the LIBOR fixings protocols.  The Barclays focus is likely due to a number of factors.  One may be the simple practical difficulty of ex ante regulation versus ex post litigation, particularly in an environment that is a state of near-continuous flux.  Relatedly, even within the realm of ex post litigation, actions against individual banks are mechanistically far more feasible than are broad indictments or ex ante regulatory pronouncements affecting an entire industry (even if the industry is in some way jointly “culpable”).  Finally, many types of enforcement action are also plausibly motivated (at least in part) by careerist norms among enforcement regulators. It is reasonable to assume that enforcement officials aspire to participate in high profile cases, either to ascend internal promotion ladders or to perfect an exit option to private industry. If a regulator entered the profession out of either motivation, significant financial scandals are an ideal target of opportunity.  

Intra-Bank Culture

A final, somewhat more direct (if not obvious) source of non-compliance culture was the reporting banks themselves.  Although the proposition that banks will manage themselves to maximize profits is hardly a novel one, it gained new traction by the beginning of the 21^st century when their business prospects began to expand as a result the significant loosening of regulatory manacles described above.

Accordingly, two discrete “phases” of misreporting are addressed in the FSA’s Barclays Notice.  The first occurred largely before mid-2007, and involved a pattern or practice where a bank would “shade up” or “shade down” its reported cost of capital in order to distort resulting LIBOR to benefit the bank’s current derivative positions.  In the second phase, (which reached maturity at the same time as the Wall St. Journal investigation described above), banks are alleged to have systematically reported their cost of debt so as to dampen – somewhat ironically – public media coverage and/or regulatory scrutiny. 

The first phase of the LIBOR misreporting scandal described above is notable by virtue of the conflict it presents between different quarters within the bank.  The interests of the fixings submitters versus those of the proprietary trading desk at the bank.   While it is possible the submitters were directly financially motivated by the belief that profits on Barclays’ trading positions would be distributed across the firm, a more plausible theory is that Barclays (and possibly other banks) gave its imprimatur to a culture of backscratching and support to its highest margin units –particularly its trading desk.  

So, What Now?

The optimal design (or redesign) of LIBOR may well be one of the most challenging problems of the next few years.  It is clear – as noted in the recent Wheatley Review – that robust and reliable benchmark rates are critical to the efficient operation of capital markets. Although various sorts of organizational firewalls have been suggested (such as the Volcker Rule) that could possibly reduce the organizational conflicts of interest within banks, that does little to address other plausible drivers of current crisis.  Another proposal (largely embraced by the Wheatley Review) is to require more direct bank regulatory oversight (from the Fed or the Bank of England) in the LIBOR fixings process.  Such interventions would remove many of the incentive (and culture) problems introduced by the BBA/Reuters. Their ability to deter manipulations of survey responses remains in question without external calibration metrics.  Perhaps a more reliable approach (and one that could be combined with greater oversight) would be to marshal more observable market rates from swap markets as a substitute for – or check on – reported rates.  A key concern for this last approach, however, is the maintenance of deep and liquid market inticatives – markets whose operations may depend (ironically enough) in part on a reliable LIBOR.