Libor rate fixing scandal reveals the rot at the heart of the financial system

In a must read Guardian column, Will Hutton looks at the Libor rate fixing scandal and concludes that real reform, rather than unsettling the global economy and financial system, is 'the platform on which a genuine economic recovery will be built'.

If the Libor rate fixing scandal teaches us anything, it is that the starting point for real reform is to bring transparency to all the opaque corners of the financial system as the Libor rate-fixing scandal could only have occurred because of the presence of opacity.

Libor interest rates are set by polling banks for an estimate of what they would pay rather than what they actually paid to borrow in the unsecured interbank lending market.  It was this opacity that allowed the bankers to engage in bad behavior by manipulating their estimates so that Libor moved in ways that were beneficial for their trading positions.

Real reform starts with transparency because our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

The FDR Framework works on the simple notion that if market participants have access to all the useful, relevant information in an appropriate, timely manner, knowing they are responsible for all gains and losses, they will use this information to make an independent assessment and fully informed investment decisions.

Where there is opacity, like banks and structured finance securities, the FDR Framework doesn't work. Market participants do not have the information needed to make an independent assessment and fully informed investment decision.

Real reform starts with ensuring that the FDR Framework applies to all areas of the financial system.  This means bringing transparency to all the opaque corners of the financial system.

This is the year the consensus changed. Around the world, policy-makers, regulators and bankers recognised that the legacy of the 20-year credit boom up to 2008 is more corrosive than all but a few realised at the time. The bankers – and the theorists who justified their actions – made a millennial mistake. 

Navigating a way out of the mess was never likely to be easy, but it is made harder still by not recognising the magnitude of the disaster and the necessary radicalism involved if things are to be put right.

Your humble blogger a) realized how corrosive the build up of opacity was and b) that the starting point for navigating out of the mess is transparency.

If there were any last doubts they were dispelled by the record $1.5bn fine paid by the Swiss bank UBS for "pervasive" and "epic" efforts to manipulate the benchmark rate of interest – Libor – at which the world's great banks lend to each other. 

The manipulation was at the behest of the traders who buy and sell "interest rate derivatives", whose price varies with Libor, so that cumulatively billions of pounds of profits could be made. Nor was UBS alone. 

What is now evident is that all the banks that made the daily market in global interest rates in 10 major currencies were doing the same to varying degrees. 

There was a complete disdain for the banks' customers, for the notion of custodianship of other people's money, that was industry wide. It is hard to believe this culture has evaporated with the imposition of a fine. 

No banker falsifying the actual interest rates at which he or she was borrowing or lending, or trader who requested that they did so, had any sense that there is something sacred about banking – that the many billions flowing through their hands are not their own. It was just anonymous Monopoly money that gave them the opportunity to become very rich. The UBS emails, which will be used to support criminal charges, could hardly be more revealing. This was about making money from money for vast personal gain....

One of the reasons for bringing transparency to the banks is that sunlight is the best disinfectant and as such is far more powerful as an agent for cultural change than a fine that is simply a cost of doing business.

The Libor scam is an object lesson in how finance taxes the rest of the economy. 

Plainly, the final buyers of the mispriced interest rate derivatives could not have been other banks, otherwise they would have lost money and we know that they all made profits. In any case, they were part of the scam. 

The final buyers of the mispriced derivatives were their customers. Some must have been large companies, but many were those – ranging from insurance companies and pension funds to hedge funds – who manage our savings on our behalf.... 

Bank managements are presented as ignorant dolts, fooled by rogue traders. They were no such thing. 

The interest rate derivative market is many times the scale than is warranted by genuine demand precisely because it represented such an effective way of looting the rest of us. 

The business model of modern finance – banks trading on their own account in rigged derivative markets, skimming investment funds and manipulating interbank lending, all to underlend to innovative enterprise while overlending on a stunning scale to private equity and property – is not the result of a mistake. 

It represents a series of choices made over 30 years in which finance has progressively resisted any sense it has a duty of custodianship to its clients or wider responsibilities to the economy. It was capitalism allegedly at its purest. We now understand it was capitalism at its most rotten. It needs wholesale reform....

Please re-read the highlighted text as it highlights the need for bringing transparency to all the opaque corners of the financial system as soon as possible.