The Federal Reserve and the Libor Scandal

By SIMON JOHNSON

Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

On June 1, 2008, Timothy F. Geithner â€" then president of the Federal Reserve Bank of New York â€" sent an e-mail to Mervyn A. King and Paul Tucker, then respectively governor and executive director of markets at the Bank of England. In his note, Mr. Geithner transmitted recommendations (dated May 27, 2008) from the New York Fed's “Markets and Research and Statistics Groups” regarding “Recommendations for Enhancing the Credibility of Libor,” the London interbank offered rate.

The recommendations accurately summarized the problems with procedures surrounding the construction of Libor â€" the most important reference interest rate in the world â€" and proposed some sensible alternative approache s.

This New York Fed memo stands out as a model of clear thinking about the deep governance problems that allowed Libor to become rigged.

At the same time, the timing and content of the memo raises troubling questions regarding the Fed's own involvement in the Libor scandal â€" both then and now.

According to the recent order against and settlement with Barclays by the Commodity Futures Trading Commission, the Libor “market” had by 2005 become a hotbed of collusion and price-fixing, in which reported interest rates were being manipulated both up and down to the advantage of individual traders and, sometimes, to benefit the banks that employed them.

These activities were widespread, representing â€" depending on your reading of the details â€" some combination of a complete breakdown of compliance and control at Barclays and presumably other banks (mentioned but not yet named by C.F.T.C.) and a pattern of apparent criminal fraud.

The New York Fed was apparently aware of Libor-rigging at some level in 2007 and serious concerns â€" although presumably not the full details of what the C.F.T.C. later established â€" had reached the most senior levels of the Federal Reserve System by early 2008.

In response to a question from Senator Pat Toomey, Republican of Pennsylvania, at a hearing on Tuesday of this week, the Fed chairman, Ben S. Bernanke, confirmed that he became aware of Libor-related issues in April 2008 (see Page 23 of the preliminary hearing transcript from Congressional Quarterly's Transcripts Wire; the other quotations below are from the same source, which is available by subscription only).

There are three questions that Mr. Geithner and his colleagues are likely to face in Congressional testimony on Libor. (The House Financial Services Committee has already announced it will hold hearings.)

First, why didn't Mr. Geithner tell Mr. King the full depth a nd motivation for his concerns?

Both Mr. King and Mr. Tucker say they did not learn of accusations of dishonesty until recent weeks. What exactly did Mr. Geithner communicate as the specific context and rationale for his reform memo? Did he really only talk in general and vague terms, rather than about the detailed and apparently credible accusations regarding Barclays?

Officials at this level speak with each other on a regular basis. There was ample opportunity for full sharing of relevant information.

Second, why didn't the Fed do anything itself about the rigging of Libor, including deliberate misrepresentation of information by people at big banks for material gain â€" keeping in mind that any action that makes a bank look better should be presumed to enhance the bonus of the people involved? This issue also came up in Tuesday's hearing.

Senator Toomey: The question is, Why have we allowed it go on the old way when we knew it was flawe d for the last four years, with trillions of dollars of transactions?

Chairman Bernanke: Because the Federal Reserve has no ability to change it.

Mr. Bernanke emphasized that Libor-rigging is a major problem but was adamant that the Fed bore no responsibility for what happened, adding:

We have been in communication with the British Bankers' Association. They made some changes, but not as much as we would like. It is, in fact, it is, you know, it's not that market participants don't understand how this thing is collected. It is a freely chosen rate. We're uncomfortable with it. We've talked to the Bank of England.

Mr. Bernanke's answer raises â€" but does not address â€" the central issue. The Federal Reserve is responsible for the “safety and soundness” of the financial system in the United States. Does allowing suspicions of fraud to continue unchecked at the heart of this system help to sustain the credibili ty and legitimacy of markets? Surely not.

Trust is essential to all financial transactions. When trust evaporates â€" or is smashed to oblivion through reckless and self-serving behavior at megabanks â€" the consequences can be dire.

The severity of the financial crisis in fall 2008 can be directly attributed to the collapse of trust among financial institutions. Cheating on Libor was not the only cause of this collapse but â€" if Mr. Bernanke is right and market participants knew what was going on â€" it must have contributed to it. Concerns about governance may be tolerated in boom times; when the economy goes sour, investors worry much more about who is hiding problems and may be about to collapse.

The Fed has jurisdiction whenever the safety and soundness of the financial system is at stake. Scott Alvarez, general counsel at the Board of Governors, acknowledged this point in a briefing to Senate staff members last week. According to The Financial Times:

In response to questions from Senate aides, Mr. Alvarez said that the Fed was unable to do more because the alleged manipulation of Libor did not constitute a so-called “safety and soundness” concern â€" a term used by bank regulators to signify threats to a lender's viability.

It is hard to see how Mr. Alvarez and his colleagues could have been more wrong â€" manipulation of Libor most definitely raises safety and soundness concerns.

Third, why wasn't the impact of potential Libor-related litigation included in recent stress tests for the American banks that may prove to be involved?

Three American banks are involved in Libor panels today â€" and apparently also during the period in question. (I have asked the British Bankers' Association to confirm this and other details; it has indicated a willingness to help but was unable to respond by my deadline, and I will report on its information in a future post.) Bank of Ameri ca is a member of the United States dollar Libor panel; Citigroup belongs to several of the larger Libor panels (including the United States dollar, the British pound and euro); and JPMorgan Chase is present on 9 of the 10 Libor panels.

One argument now being advanced from some financial circles against large fines for the banks involved is that this would reduce their shareholder capital enough to constitute a risk to the financial system.

More broadly, we do not yet know with whom Barclays personnel colluded â€" or the full extent of the damage to investors and borrowers. Consequently, no one yet knows the scale of balance-sheet damage that will be done by settlements of Libor-rigging claims.

This could even become a “tobacco moment,” in which an industry is forced to acknowledge its practices have been harmful â€" and enters into a long-term agreement that changes those practices and provides continuing financial compensation. Certainly attorneys gen eral from states that have been damaged will be thinking along these lines.

Yet in his conference call with analysts on July 13, JPMorgan Chase's chief executive, Jamie Dimon, was already discussing the possibility of resuming share buybacks later this year. It is hard to know how the Fed could agree to such reduction in shareholder capital. It is also hard to understand why the Fed continues to allow the payment of bank dividends under these circumstances.

The Libor scandal is different in some ways than other recent financial fiascos; it involves egregious, flagrant criminal conduct, with traders caught red-handed in e-mails and on tape. This is the definition of a “smoking gun.”

It is inexcusable and indefensible if these traders aren't soon brought to account, facing criminal charges in court. That should be first step, with the full support of the Fed (although it obviously doesn't run criminal investigations).

As Dennis Kelleher of Better Markets told Eliot Spitzer this week (see from around 3:29 in this excerpt): “Slapping handcuffs on these traders has to be the next step,” adding, “Handcuffs, squeeze them, handcuffs, squeeze them and move up the chain.” Mr. Kelleher continued, “This is an open and shut case” and “this is egregious criminal conduct.”

He went on: “There's never been any accountability on Wall Street. Wall Street's a high-crime area and the criminals are just let to run free. This would never be tolerated anywhere else in America, and it's time to end the two sets of laws.”

This is what should have been done years ago for all the illegal behavior that led up to the crisis.

And the Fed should want this clean-up, in the interest of financial stability and ensuring future economic prosperity. The integrity and legitimacy of markets are at stake.

There are slight glimmers of hope that Fed thinking may be heading in the right direction, at least in thin king about the structure of the problem.

At Tuesday's hearing, Senator Sherrod Brown, Democrat of Ohio, listed the litany of big banks' recent wrongdoings and the consequent damage, and told Mr. Bernanke: “So many of our biggest banks are too big to manage and too big regulate. I think this behavior shows they're too big to manage and too big to regulate.”

Mr. Bernanke's reply was sensible. “I think the real issue is too big to fail,” he said, adding, “And I think that if banks are really exposed to the discipline of the market that we'll see some breakups of banks.”

Mr. Bernanke feels that the discipline of the market is already working. This is harder to see, particularly in the light of what we learn about bank behavior in connection with Libor.

Let's hope he is starting to see issues in the financial sector more clearly: Too big to fail is too big to exist â€" or to behave in accordance with the law. This is a problem of vast, nontrans parent and dangerous government subsidies; the market cannot take care of this by itself.