Cooking the Books

July 1, 2012

In his 1776 book The Wealth of Nations, Adam Smith, founding father of free-market economics, wrote, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

The truth of this observation was recently borne out when a series of lawsuits alleged that some of the world’s largest banks were engaging in manipulating the market.  In cases filed in Europe and the U.S., investors accused several banks of colluding to hide their true borrowing costs.  These banks include UBS, Credit Suisse, Deutsche Bank, Bank of Tokyo-Mitsubishi UFJ, Citigroup, HSBC, JP Morgan Chase, Mizuho Financial Group, Rabobank Groep, Royal Bank of Scotland, Société Générale and Sumitomo Mitsui Banking Corporation.  The allegations revolve around the LIBOR (London Interbank Offered Rate), which is used to determine the interest rate of over $350 trillion worth of financial products, including mortgage loans, credit card rates, bond prices and complex derivatives.

Here’s how it works.  Managed by the British Bankers’ Association, the banking trade body, the LIBOR is determined from the advice of a panel of nineteen banks of what rate those banks could borrow funds.  This exercise depends on the banks honestly reflecting the market rate, with no independent check.  LIBOR also acts as a barometer for the financial system. Increases in the LIBOR means that banks are obliged to pay the fund themselves, thus reducing profits. During the global financial crisis, high LIBOR rates threatened to push them over the edge.  This provides a strong financial incentive to cook the books, and during the credit crisis of 2008, regulators estimated that the LIBOR stood around 0.3 percentage points lower than their actual borrowing rates.

It has since been alleged that by reporting artificially low interbank interest rates to the LIBOR panel, banks profited by pocketing the difference with the real rate, which is what they charged their customers.  The system is not difficult to manipulate, provided the banks act in unison.   Therefore, obtaining proof of this scam can be difficult. The breakthrough came when one of the alleged conspirators, UBS, confessed to teaming up with others to manipulate the LIBOR.  Its mea culpa is anything but noble, as the Zurich-based lender hoped to insulate itself from huge fines that could result from a successful prosecution.  In another breakthrough, Barclays has agreed to pay more than $450 million to resolve accusations that it attempted to manipulate key interest rates, the first settlement in the sprawling global investigation being conducted by a number of governments.

While governments investigate the alleged cartel, Charles Schwab Corp., a San Francisco–based brokerage firm and investment manager, decided to act by suing eleven major banks, including Bank of America Corp., Citigroup, Inc. and JPMorgan Chase & Co.  This legal suit accuses the banks of conspiring to depress LIBOR by understating their borrowing costs, thereby lowering their interest expenses on products tied to the rates, according to the lawsuit. The banks “reaped hundreds of millions, if not billions, of dollars in ill-gotten gains,” according to Charles Schwab.  The LIBOR rate, produced under the auspices of the century-old British Bankers’ Association, represents self-regulation and was part of the deregulatory wave that washed over the British financial system in 1986.

Now back to Adam Smith.  While strongly pro-market, he did not see corporations as necessarily a friend of the market, as his observation about cartels proves.  In another passage, he warned governments against trusting the advice of private interests, particularly when it comes to regulations.

The proposal of any new law or regulation of commerce which comes from [merchants and master manufacturers] … ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention.  It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

Heaven knows what he would have thought of self-regulation, which is the heart of the LIBOR scandal.

2 Comments for this entry

  • QT says:

    See, this is what I don’t understand. When banks (or any other financial institution for that matter) starts cheating the system in order to avoid a crisis and/or make a profit for themselves, why do they not realize that they’re only going to create a spectacular catastrophe later on? It NEVER FAILS, and yet, they still don’t seem to learn their lesson.

  • Henry Holmes says:

    Whenever I see or hear of someone inventing complex or elaborate methods of cheating, I always think, “If only you could put that kind of ingenuity into actually accomplishing that goal honestly, there’s no telling how much better off you’d be by now.”

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