Reservoir Dogs is a hit movie made in 1992, which has now acquired a cult status. It is often described as the greatest Independent Film of all time. In the final scene of the movie, a bunch of men in suits are all blindly shooting at each other. The movie plot involves a diamond robbery and had six characters called Mr Blonde, Mr Blue, Mr Brown, Mr Orange, Mr Pink and Mr White. The recent Libor controversy resembles the final scene of the movie except that the characters are bankers in suits and careers are getting finished instead of lives. The weapons are statements, emails and innuendos. Instead of a diamond heist, the main protagonist of the Libor plot is a person called Bob Diamond, an American banker, who till three weeks ago was the group CEO of the British bank, Barclays.
Another important character in this Libor story is Paul Tucker, deputy governor of the Bank of England. His career and reputation as a central banker has been irreversibly damaged in the recent controversy, because apparently he tacitly told Barclays to manipulate Libor. He was seen as a front-runner to succeed Sir Mervyn King, the current Governor of the Bank of England. Another head to fall has been Jerry del Missier, the former Barclays chief operating officer who last week admitted ordering his staff to submit false interest rates because he believed his action had been sanctioned by the Bank of England. He was earlier the co-head of Barclays? investment banking division and was promoted as the COO, as recently as on June 22. He would probably go down in banking history as the COO with the shortest tenor of a mere dozen days.
Another character to suffer an inglorious exit from banking is Marcus Agius, the former group chairman of Barclays. He too has had to resign as he acknowledged he is eventually responsible for what happened at Barclays. There are more heads that are expected to roll as the three-week-long controversy is nowhere close to its end.
So, let?s understand the central character of this controversy called Libor. Libor can be thought of as the most important interest rate in banking, as it defines the interest rate of hundreds of trillions of dollars worth of loans and derivative contracts. Just as floating reference rate is used as a benchmark in India to calculate interest on floating-rate home loans, similarly many retail and corporate loans and derivative contracts in the US and Europe use Libor as the benchmark floating rate to calculate interest. A common misconception that you hear in the media is that Libor manipulation by these large banks have hurt the average person. Actually, for a change, manipulation by bankers have benefited the common man instead of affecting him adversely. Bankers colluded to keep the benchmark rate low and this meant that the average person paid less interest on his loans. Of course, it is a zero-sum game so mortgage lenders and corporates receiving floating rate on swap contracts have lost, while home loan borrowers and large banks who are net payers of Libor have gained.
There seem two possible endings to this Libor story. One ending is that all bankers kill each other?s careers and credibility and, in the process, Libor becomes gradually extinct over a period of time. Or, all bankers and their industry body?British Bankers Association?which polls for Libor, collectively find a solution.
So, what could be a possible solution. The solution lies in Europe?s financial history. There have been benchmarks in the past that have lasted for centuries, unlike Libor that is less than three decades old. The benchmark that lasted for four centuries?from the twelfth to the sixteenth century?was the exchange rate of gold against silver. There was a polling process by which the exchange rate of one gold coin in terms of silver coins was decided in guilds during the renaissance period, much the same way Libor is determined now by the British Bankers? Association. The biggest guild during the renaissance period was Arte del Cambio, which used to set prices for how many silver coins equalled one gold coin through a polling process. At the end of each trading day, all the guild participants were allowed to submit estimates of the next day?s exchange ratio to the guild chief instead of a select few as with Libor. Even though the participation was broad-based, each guild participant was selected through a peer review based on honesty, financial soundness and commitment to obey guild rules. Moreover, penalties for dishonesty were very harsh, so as to be dauntingly prohibitive. This renaissance time Florentine system not only allowed for many more estimates to determine rates (which is one suggestion to remedy the Libor process) but also enforced exemplary penalties on dishonest participants. Like spot fixing in cricket, unless the penalties are prohibitive and rigidly enforced, it may be difficult to regulate bad behaviour.
Perhaps regulators might want to glean through history pages for inspiration when crafting new regulations. The ending to this Libor story doesn?t have to be that of Reservoir Dogs.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance
