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libor: politics and financial regulation July 5, 2012

Posted by Bradley in : financial regulation , trackback

Bob Diamond appeared before the Treasury Select Committee yesterday to discuss Libor. On one level the reviews in Parliament and at the FSA are supposed to be about working out how to ensure this particular problem doesn’t recur. And the options on the table seem to be very focused on Libor. Should the regulators require that Libor be based on transactions rather than on opinions, should setting Libor be a regulated activity etc. We have seen some hints that the issue is seen as part of a larger issue – the banking culture issue – but that is both more significant and harder to find a regulatory fix for.

There’s another larger issue here. Financial stability concerns make regulators focus on systemically important financial institutions (for example this recent Basel Committee Consultation on domestic systemically important banks). But what about trying to identify the point at which practices become systemically important? Some years ago, when Libor was a bespoke rate fixed by mechanisms specified in individual transaction documents it wasn’t one rate that all could use. According to the BBA’s website, banks asked it to work on providing uniformity:

The BBA was asked by the banks it represents to bring a measure of uniformity into the market and to devise a benchmark to act as a reference for these new instruments. Rather than negotiating the underlying rate or forming rates by taking averages of ad-hoc panels, banks could now use a standard rate. This facilitated the operation of markets and made benchmarking more transparent and objective.

The standardization of Libor increased its use as a rate of interest across a range of transactions around the world. But standardization may be a source of systemic risk if it makes particular behaviours more pervasive. We know that the way in which securitizations were structured involved invisible systemic risks. We are dealing with issues around the regulation of derivatives. But all of these issues are linked by standardization of financial transactions and practices.

Then there’s the politics. Did the Government or Bank of England encourage banks to manipulate Libor during the financial crisis. This issue is going to hang around for a while. The press likes it. Paul Tucker wants to speak to the Treasury Select Committee to clarify what he said in October 2008. But any financial regulation, and a lot of normal governmental activity, affects the way the markets work. Rescues of failing financial firms involve some manipulation of the financial markets. Will Spinney at the ACT gives a number of examples of governmental manipulation of financial markets. I wrote a short paper about the crisis where I said:

The global financial crisis thus renders visible and urgent a perennial (although often ignored) tension in financial regulation with respect to the extent to which governments should intervene to fix the financial markets.

This issue deserves more serious consideration than the irresponsible throwing around of partisan criticism we are seeing – reminiscent of snowball fights in a playground (or whatever they do at Eton) – that it is getting. Precisely what governmental interventions in the financial markets are legitimate, and what are not?

update: Note Jonathan Portes:

The lack of discussion about the structure of these key funding markets in any of the UK banking reform proposals is a very serious omission.


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