Friday, July 13, 2012

Libor-gate shines bright light on financial regulators

As reported by the Telegraph, the focus on the Libor manipulation is now shifting to the financial regulators.  Specifically, what they knew, when they knew and, most importantly, what they did about it.

Regular readers know that the lesson to be learned from the Libor manipulation is not to let opacity into the financial system.

Regular readers also know that the solution as it relates to Libor is to require banks to disclose all of their trades involving funding the banks.  This trade data can then be used to construct Libor in a transparent manner.

So much for the solution.

What we are in the process of finding out is how poorly the financial regulators performed their primary function of ensuring transparency so that every market participant had access to all the useful, relevant information in an appropriate, timely manner to make a fully informed investment decision.

It is hard to make a fully informed investment decision on a security where the buyer receives Libor when the regulators know and don't disclose that the Libor interest rate is being manipulated.

It just gets worse. If Sir Mervyn King was up to his waist in Libor before, now he’s drowning in it.

And the Bank of England Governor’s not the only one – top brass at the Financial Services Authority and the British Bankers’ Association are hardly doing much better. 
The decision to release emails detailing how Tim Geithner warned the Bank in June 2008 about fears that Libor could be manipulated have opened a new can of worms.
Then head of the Federal Reserve Bank of New York, Geithner’s email recommended steps to “improve the integrity and transparency of the rate-setting process... including procedures designed to prevent accidental or deliberate misreporting”. 
Those views were based upon conversations between US regulators and banks, including Barclays. The banks, it turns out, admitted as long ago as mid-2007 that they were low-balling Libor rates. 
The message from Geithner’s email was crystal clear – integrity and transparency were not words easily associated with Libor setting. 
Or any other opaque corner of the financial system (think structured finance for example).
The email – not to mention the low-balling testimonies which it beggars belief UK authorities were unaware of – should have sent alarm bells ringing.
 And why did Mr. Geithner not mention the confession of the Barclay's trader to the NY Fed?
The Bank and the FSA ought to have been kicking tyres and asking questions but instead the matter was passed on to the British Bankers’ Association – an industry body made up of the very banks now at the centre of the scandal.
Post the financial crisis, based on my experience with trying to bring transparency to structured finance, nothing has changed and the financial regulators still pass the issues on to the sell-side run associations.

This is critically important and would have been focused on much sooner had the financial regulators informed the markets that Libor was being manipulated.  
That no one at the Bank or the FSA asked whether that was the right approach is hardly credible. That’s light-touch regulation and then some.
Actually, it is complete regulatory capture.
When asked about Libor last month, Sir Mervyn said there had been discussions to reform the system in 2008 but “there was very little support... among the markets, among banks and, indeed, among our overseas colleagues to make the change”. 
Hello, if as regulators you only treat the banks who are manipulating the Libor rate as credible, you will find that there is no one who is concerned about Libor being manipulated for the banks' own profits.

Now that the banks, led by Barclays, have confessed that they will lie to enhance their profitability, financial regulators should immediately discount anything a banker or the lobbying groups they control says to being simple a self-serving lie and ignore it.

Back to my experience with trying to bring transparency to structured finance.

The bankers and their allies responded to a public consultation on Article 122a of the European Capital Requirements Directive.  Article 122a says regarding structured finance securities that financial institutions must know what they own and that issuers must provide the data they need so they can know what they own.

The bankers and their allies argued that the disclosure associated with opaque, toxic subprime mortgage-backed securities was sufficient to know what you own.

I too responded (the only non-bank or bank ally to respond).  My response explained that with current disclosure practices valuing subprime mortgage-backed securities was the equivalent of trying to value the contents of a brown paper bag.

My response pointed out that to actually know what you own requires observable event based reporting so that valuing these securities was the equivalent of trying to value the contents of a clear plastic bag.

Because the financial regulators see the liars as credible, they supported the idea that blindly betting on the contents of a brown paper bag was equivalent to knowing what you own.
Those comments now look difficult to square with Geithner’s email. Now US treasury secretary, Geithner will himself be accused of failing to blow the whistle loudly enough given how clear cut the problems were, but at least he put it to his lips.
Actually, Mr. Geithner did not really blow the whistle as he failed to mention that Libor was being manipulated in the run-up to reforming the financial system with the Dodd-Frank legislation.
Sir Mervyn, together with Lord Turner and Hector Sants at the FSA, look like they couldn’t even find one.
In private, US regulators are increasingly accusing their British counterparts of a glacial approach to dealing with the Libor scandal. It’s a charge that looks more powerful by the day. 
They will try to excuse the oversight as a failure of the system – Sir Mervyn was careful to point out yesterday that the Bank “did not have any regulatory responsibilities in this area” – but that won’t wash.

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