Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
One of the most famous World War II security posters read “Loose Lips Sink Ships”. The idea was to curtail careless talk that might give away valuable information to the enemy. In the great LIBOR scandal though, the problem has been too little careful talk. The basics of the LIBOR scandal are well-known. The British Bankers’ Association (BBA) provides a reference price for interbank offer rates. Under unclear oversight by the FSA and the Bank of England, at least one bank, but probably several, colluded in rigging submissions that established the reference price. The rigging has already been dated to at least 2007, but probably extends a few years earlier.
Numerous markets, e.g. shipping or coal, use different methods to provide reference prices. In most markets price fixing would be a crime. Yet reference prices are important and regulators sometimes relax strict competition policy in order to help price formation and aid overall competition. Although a number of methodological adjustments create LIBOR, e.g. brute elimination of outliers, the BBA’s method is not particularly sophisticated and fewer than 20 banks contribute to LIBOR. In our book, The Price of Fish, Ian Harris and I discuss “liquidity and lucidity among the dark pools”. Obviously, a big part of the problem with LIBOR is that banks don't actually have interbank transactions on many of the rates quite a bit of the time, so one seeks a method for calculating a theoretical price rather than having an actual “willing buyer and seller” price. The BBA has yet to recognise that it is combining instrumental factors with qualitative assessments. A combined approach needs to incorporate more sophisticated statistical techniques and more sophisticated price auctions in order to provide better information and remove the incentive to game the system.
For London, the LIBOR scandal is a severe ‘own goal’. Regulators appear to be both fools and knaves. Fools in that they failed to uncover the problem till 2008, i.e. it went on under their noses for some time. Knaves in that they failed to do anything about fixing LIBOR with any sense of urgency. Our firm, Z/Yen, runs Long Finance, exploring the question “when would we know our financial system is working?” One of Long Finance’s four programmes is Financial Centre Futures which publishes the semi-annual Global Financial Centres Index (GFCI) sponsored by Qatar Financial Centre Authority. Since the first compilation of GFCI in 2005, London has held the top spot (current score 781 out of 1,000), with New York following closely. Hong Kong and Singapore have risen during this time to join both of these centres as ‘global financial centres’ in 2011, principally on the rising perceptions of Asia and on the quality of their regulation. Being the leading global financial centre is a valuable and honourable thing that should be prized and defended through institutions and culture that prevent scandals as crass as LIBOR from happening.
The two top areas of financial centre competitiveness are quality of people and business environment, particularly regulation. Before the financial crises, quality of people was paramount. Since 2008, the business environment, particularly regulation, is paramount. However, one crucial aspect of financial centre competitiveness is hard to express. For a global financial centre to be attractive to foreign businesses it has to be perceived as “being fair to foreigners” or “treating foreigners fairly”. Fairness is signalled in many ways: ease of market entry, justice in courts, equal taxation. Fairness is also signalled by market structure. Foreigners tend to enter markets where there is no dominant advantage to the local players and there are numerous examples of competitors thriving. Ultimately a global financial centre's hold comes down to feeling and trust as much as or more than pure logic.
The LIBOR scandal makes London look as if foreigners aren’t treated fairly. I know there will be cries that overseas banks were involved and Bob Diamond is an American, but this scandal gives the impression that London’s core financial community is still “an old boys’ club”, which is terrible for trust. Insiders, including some foreigners, can take advantage of overseas fools who trust the regulators. Unable to uncover the scandal early, and unwilling to do anything about it promptly, our regulatory system is both fool and knave. Moreover, don’t be surprised to see strong, competitive attacks from other BOR products. That said, given that EURIBOR and others use similarly flawed methodologies, they too need much work to be seen as fair.
The need to relaunch, rather than fix, LIBOR is urgent. We need a strong signal to show that London is open for business for anyone prepared to accept fair regulation. Changing LIBOR is a herculean task given how fundamental it is to so many contracts. We need a serious change to the LIBOR methodology, notwithstanding the fact that such changes are likely to lead to an increase in the rates and raise litigation issues. We must revamp our regulatory structure and set out clear regulatory responsibilities. We must clean up any other markets where regulators have moved from fools to knaves. Another famous World War II security poster read “Keep Mum – She’s Not So Dumb”. For me, this isn’t a comment on the mental faculties of the Old Lady of Threadneedle Street, but a call that we need to start talking openly about radical changes that prove London is a jurisdiction where foreigners are treated fairly.
About the author Professor Michael Mainelli FCCA FCSI FBCS, Executive Chairman, Z/Yen Group
Michael’s third book, based on his Gresham College lecture series from 2005 to 2009 and co-authored with Ian Harris, “The Price of Fish: A New Approach to Wicked Economics and Better Decisions”, won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.