Keynesian Spirits


A Scam at the Heart of a £350 Trillion Market

Barclays Bank has been charged by Britain’s rejuvenated financial regulator, the Financial Services Authority, as well as the US regulator, Commodities Futures Trading Commission, for manipulating a key interest rate – the London Interbank Borrowing Rate (LIBOR).

This manipulation began around 2005 and continued for around five years. LIBOR indicates an average of borrowing rates for banks in all top currencies, and is used as the benchmark for financial contracts and interest rates around the world, which is a market worth £350 trillion.

This is how LIBOR is calculated: the British Bankers’ Association (BBA) asks each bank what rate it expects to pay to borrow from other banks for relatively short time periods – from overnight loans to 12 months in a range of currencies. It is important to note that such short-term borrowing was the primary source of funding for a lot of banks. Before the financial crisis, this rate used to be quite low, because banks didn’t see much risk in lending to each other as they were all profitable, and the markets were functioning perfectly. However, when the subprime crisis exploded, it became clear that many of the assets that banks held on their balance sheets may be worth much less than thought, all banks panicked, LIBOR shot up, and banks stopped lending to each other. Nobody was willing to trust anyone. How could they know that the bank they were lending to was fundamentally sound, and wouldn’t be bankrupt in the future?

It was in this environment that Barclays, and other involved banks, made the most by manipulating the rate. It was certainly used to boost profits, but more importantly, the banks manipulated to rate and pushed it lower during the financial crisis. This was done to convey the false signal that the banks were sound, that their borrowing costs weren’t too high, and that they didn’t need any help. Thus, Barclays was able to dupe foreign investors, mostly cash rich, but risk-averse sovereign funds, during the panicky period of 2008. Barclays, unlike RBS, said no to UK government funding, and instead asked sovereign funds to invest in the bank.

For such an important interest rate to be calculated in such a manner seems cavalier. The calculations are done in such a manner that outliers are eliminated so that one bank cannot really influence the rate, but in this episode, while only Barclays has been fined yet on this matter, others like the Royal Bank of Scotland, UBS, Bank of America, Citigroup and a dozen other banks (spanning 3 continents) are being investigated as well. Hence, this was most probably an industry-wide practice, and wasn’t solely limited to Barclays.

You can see the flaw in the above method: the BBA asks banks to supply them with their borrowing rate. What happened at Barclays was that its traders had some positions in the market – they had bought an asset, or promised to purchase it, or they had some other financial position, and a change in this crucial interest rate would benefit their trades. Thus, the traders colluded with the treasury department (which sends this information to the BBA) to supply incorrect rates and thus manipulate them. It must be noted that normally there is supposed to be no communication whatsoever between these two parties.

Here are some useful readings on this issue:

Q&A by FT 1

Q&A by FT 2

BBC’s excellent Paul Mason with a clear, detailed post on Barclays’ manipulative acts

A primer on financial products

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Insightful Readings on the Economic Crisis

Below are some of the clearest, most insightful and thought-provoking articles, essays and lectures on the economic and financial crisis that began in 2007.

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The Real Solution is Growth – Daron Acemoglu

Rethinking Macroeconomics – Jeffery Sachs

How Did Economists Get It So Wrong? – Paul Krugman

The Crisis on 2008: Structural Lessons for and from Economists – Daron Acemoglu

An Agenda for reforming economic theory – Joseph Stiglitz

Has financial development made world riskier? – Raghuram Rajan


The Wall Street Leviathan

Jeff Madrick has written a useful piece on the findings of the Financial Crisis Inquiry Commission (USA). Here are some of the most striking things he brings up:

“Bernanke told the FCIC: As a scholar of the Great Depression, I honestly believe that September and October 2008 was the worst financial crisis in global history, including the Great Depression…Out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two. “

“The single most stunning finding of the FCIC report is that if all Citigroup’s assets had been accounted for accurately, its ratio of assets to capital would have been forty-eight to one in 2007, not the twenty-two to one it had been reporting that year. The ratio of forty-eight to one was irresponsible—higher than the capital ratios at the most aggressive investment banks, such as Bear Stearns, and far higher than the capital ratios of other banks. The Fed apparently had no idea of this.”

“The legislation repealing Glass-Steagall, the Gramm-Leach-Bliley Act of 1999, had one other subtle but highly significant consequence, as the FCIC report explains. It diluted the government’s regulatory authority over the new financial conglomerates such as Citigroup. Under the legislation, the Fed, the strongest of the regulators when it did its job properly, now oversaw only bank holding companies, the umbrella organizations under which the bank subsidiaries operated. The 1999 act mandated that the Fed rely on the SEC to oversee bank subsidiaries that dealt in securities, and that the Office of the Comptroller of the Currency oversee commercial banks. The practical result was that much of importance thus fell through the cracks of the 1999 bill. The FCIC report refers to this stripped-down authority as “Fed-Lite.” The Fed failed to do its job in any case. It made no adequate analysis of the risky CDOs. As far back as 2005, a peer review by other Federal Reserve banks criticized the New York Fed, then under Tim Geithner, for inadequate oversight.”


How useful is the financial services sector?

Before the recent financial crisis ravaged the lives of tens of millions and jolted the certainties of academic economists and policymakers, regulatory bodies like Britain’s Financial Services Authority used to boost that they offered a ‘light touch’ regulation. Regulatory bodies worldwide seemed to be in a race to lower regulatory standards and openly show their faith in the invisible hand.

No longer. Adair Turner, chairman of the FSA, has taken Keynes’ words to heart (When the facts change, I change my mind. What do you do, sir?) and has taken the lead in thinking beyond the standard models and has been making strong, rather ‘radical’ policy proposals for the financial services sector. No one disagrees with the idea that a well-functioning, innovative financial sector is essential for any economy, but disagreements about safety of individual institutions and the whole system, remuneration and other issues persist. Hence, original thinking should be and is very welcome.

Below are the main points from Mr. Turner’s recent speech at Cambridge University:

1/ Taxation: While core capital requirements will be increased from 2% to 7%, they should ideally be at least double, if not treble this number.

2/ Higher pay: The trend to defer bonuses and award them in shares may have the perverse effect of actually increasing bankers’ pay in the long-term. On the other hand, we’ve already heard that bankers are using certain instruments to actually get round this problem of deferred payment.

3/ Rent extraction: A large amount of the banks’ activities essentially extract rent and do not add to social welfare:

(a) Tax management activities earn banks large fees and help firms avoid paying tax to the exchequer.

(b) Creation of obscure products that hide risks for investors and hence lead to unbearably high risks being taken not just by individual investors but by big institutional investors.

(c) Financial products offering so-called protection lead to greater volatility, which sets of another product creation cycle to allow investors to hedge risks from this increased volatility.

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BBC’s Peston on Turner speech

John Cassidy on the usefulness of Wall Street