Let me preface what follows by emphasizing that I have tremendous respect for Alison Frankel. She's one of the best journalists covering law/business matters around. But I (respectfully, of course) dissent from her recent column on the meaning of the UBS LIBOR settlement.
Frankel tees up her argument with a quick rundown of the admittedly appalling facts:
UBS disclosed its cooperation with antitrust authorities more than a year ago, so it’s no surprise that the bank was penalized, though the size of the penalty – a total of $1.5 billion to United States, UK and Swiss regulators – was certainly notable, particularly because UBS had been granted leniency for some parts of the Libor probe. But what’s most striking about the FSA’s filing on UBS, just like its previous notice on Barclays, is the brazenness of the misconduct the report chronicles. According to the FSA, 17 different people at UBS, including four managers, were involved in almost 2,000 requests to manipulate the reporting of interbank borrowing rates for Japanese yen. More than 1,000 of those requests were made to brokers in an attempt to manipulate the rates reported by other banks on the Libor panel. (Libor rates, which are reported for a variety of currencies, average the borrowing rates reported by global banks; 13 banks are on the yen panel.)
The corruption was breathtakingly widespread. According to the FSA, UBS took good care of the brokers who helped the bank in its rate-rigging campaign: Two UBS traders whose positions depended on Libor rates, for instance, engaged in wash trades to gin up “corrupt brokerage payments … as reward for (brokers’) efforts to manipulate the submissions.” In one notorious 2008 phone conversation recounted in the FSA filing, a UBS trader told a brokerage pal, “If you keep (the six-month Libor rate) unchanged today … I will fucking do one humongous deal with you…. Like a 50,000 buck deal, whatever. I need you to keep it as low as possible … if you do that … I’ll pay you, you know, 50,000 dollars, 100,000 dollars … whatever you want … I’m a man of my word.”
So what does Frankel makes of this?
Everyone who has ever claimed that the financial industry is overregulated should be forced to read the final notice on UBS’s manipulation of the London interbank offered rate issued Wednesday by the United Kingdom’s Financial Services Authority. ...
If we’ve learned nothing else in the last four years, we should at least acknowledge that some people within financial institutions, if left to their own devices, will behave dishonorably and even illegally. The drive for profits in people like the UBS traders and their brokerage conspirators, as described in the FSA filing, is obviously more powerful than any qualms about morality or fear of being found out.
That’s why moaning about Dodd-Frank whistle-blowers or duplicative actions against the banks rings hollow. Insiders will abuse the power of asymmetry: They know about their own secret conduct and we don’t. We’re playing by their house rules, and regulators armed with subpoenas are the only hope we’ve got.
First, LIBOR differs from the other cases she describes in that the LIBOR process was essentially unregulated. The British Bankers’ Association (BBA) is a trade association for the UK banking and financial services industries, representing over 200 member banks. It created LIBOR in 1986 to serve as the benchmark interest rate for commercial bank lending on the London interbank money market.
The method by which LIBOR was calculated gave banks considerable room for strategic behavior. First, because banks self-reported, there was no system for verifying their answers. Indeed, because LIBOR was based on the panel banks’ estimates rather than actual transaction data, there was nothing to verify. Second, the key term “reasonable market size” was “intentionally left broadly defined,” which again created opportunities for banks to make strategic tweaks in their estimates by varying what they regarded as a reasonable loan size. Third, because the panel size was relatively small, misreporting by even a few participating banks could shift the LIBOR benchmark. Fourth, because each panel bank’s submission was made public almost immediately, it easy for banks colluding to move the benchmark in a particular direction to ensure that their partners had complied with the agreement. Even in the absence of outright collusion, real-time publication made it possible for a single bank to make good estimates of where their submission needed to be set in order to influence the outcome of the benchmarking process.
In April 2008, the Wall Street Journal reported suspicions that some of the LIBOR panel banks were taking advantage of these opportunities for strategic misbehavior. During the financial crisis of 2007-2008, some banks allegedly did not want to report the high interest rates they were being charged for interbank loans because they did not want to alert regulators and markets of the full extent of the economic difficulties in which those banks found themselves. Prompted by the Journal’s reporting and regulatory pressure, the BBA undertook an expedited review to determine whether banks had been filing false reports.
In response to the concerns flagged by the Journal, the BBA in June 2008 made several changes to the way in which LIBOR was calculated. First, the number of panel members was increased. Second, the BBA announced plans to police the accuracy of the reported estimates more carefully. Broader changes, including changes to the definition of LIBOR, however, were rejected. Indeed, the BBA’s critics dismissed the changes as minor tweaks unlikely to change the fundamental problems with how LIBOR was set.
In sum, the admitted fact that LIBOR was underregulated, doesn’t mean that other sectors of the financial market are not overregulated.
Second, Frankel’s trust in “regulators armed with subpoenas” is particularly misplaced in this context. During the financial crisis, both government and private sector actors viewed a high LIBOR submission as a sign of financial weakness on the part of the submitting bank. Barclays admitted to having reduced the rates it submitted so that its submission fell within the mid-range of the panel banks. Internal Barclays documents showed that top Barclays managers had expressed concern throughout the financial crisis that Barclay’s relatively high LIBOR submissions were attracting negative media attention and raising questions about the bank’s creditworthiness. This led to a directive being issued by a senior bank manager to Barclay’s LIBOR submitters that the bank “should not stick its head above the parapet.” Jun Anthony Garcia, “Fixing the Benchmark”—Wheatley Considers LIBOR Overhaul at 2, available at https://ssrn.com/abstract=2143137.
Troublingly, Barclays “released evidence that can be interpreted as an implicit nod from the Bank of England (and Whitehall mandarins)” approving of the bank’s fudging its LIBOR submissions. During the crisis, the U.K. government—like many others—was desperate “to bolster confidence in banks and keep credit flowing. The suspicion is that at least some banks were submitting low LIBOR quotes with tacit permission from their regulators.” How Britain’s Rate-Fixing Scandal Might Spread—And What to do About it, The Econ. (July 7, 2012), available at https://www.economist.com/node/21558260.
The same may have been true of other key global regulators. In the US, for example, the New York Federal Reserve Bank—then run by Timothy Geithner, who subsequently served as Treasury Secretary in the first Obama administration—reportedly was aware as early as August 2007 of possible LIBOR manipulation but failed to aggressively respond. Rachelle Younglai & Pedro da Costa, Geithner Says Did All he Could to Address LIBOR Problem, Chi. Trib. (July 26, 2012), available at https://articles.chicagotribune.com/2012-07-26/news/sns-rt-us-usa-geithnerbre86o0vc-20120725_1_libor-responsibility-for-market-manipulation-british-bankers-association.
Frankel’s regulators with subpoenas knew what was going on (or at least should have known) and did absolutely nothing. So how exactly will empowering them help? (Well, I’m working on an article to address the issue.)
Please note that in the case of LIBOR I am not reflexively opposing new regulation of the LIBOR process. To the contrary, I am currently working on an article on LIBOR reform that embraces reasonable new regulatory constraints.
But I would also remind Frankel that the chief lesson of financial bubbles is that they tend to lead to bad laws. See generally Larry E. Ribstein, Bubble Laws, 40 Hou. L. Rev. 77, 79 (2003); Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, 114 Yale L.J. 1521, 1590 (2005).
I detail the problem at length in my book Corporate Governance after the Financial Crisis.
The history of securities regulation in both the United Kingdom and the United States teaches that new regulation is an inevitable political response to financial crises and scandals. In a bubble period, such as the one that preceded the financial crisis of 2007-2008, major regulatory initiatives are relatively rare, because interest groups like shareholders and consumers are lulled into inaction by the seemingly ever-rising value of their portfolios. At the same time, however, the stage is being set for a post-bubble burst of regulation. In the euphoria associated with a bubble, regulators and private gatekeepers tend to let their guard down, potential fraudsters see an explosion of opportunities, and investors become both more greedy and trusting. The net effect is a boom in fraud during bubbles, especially towards the end, when everybody is trying to keep the music going. When the bubble inevitably bursts, investigators reviewing the rubble begin to turn up evidence of speculative excess and even outright rampant fraud. Investors burnt by losses from the breaking of the bubble and outraged by evidence of misconduct by corporate insiders and financial bigwigs create populist pressure for new regulation.
It is in the post-bubble environment, “when scandals and economic reversals occur” and grab the attention of the public, that regulators and legislators act. This is hardly surprising, because such periods typically involve an upswing in populist anger and accompanying intense public pressure for action. This pattern is a reoccurring phenomenon in American law, going back even before the New Deal. Indeed, the same pattern of boom, bust, and regulation can be seen in both American and British legal history far back into the Nineteenth Century.
The trouble is that new financial regulations adopted in a post-crisis environment often “impose regulation that penalizes or outlaws potentially useful devices and practices and more generally discourages risk-taking by punishing negative results and reducing the rewards for success.” Ribstein supra, at 83.
As I will detail in my forthcoming article, I think there is a good chance of avoiding this phenomenon in the case of LIBOR. But I don’t see why that makes the LIBOR case anything more than the exception that proves the rule.