In the last week, we saw major developments in two big scandals – Libor rigging and swap mis-selling in the UK – and the end of the second quarter which is likely to draw a line under a third big scandal – the ‘London Whale’ losses at JP Morgan. I have some thoughts about these three scandals and their implications for banking and regulation, and my view is that one thing connects them: the growth of over-the-counter derivatives and London’s place at the centre of this growth. I will split up my analysis into three separate questions and answers.
Q: Why did the Libor rigging happen and what are the implications?
A: Libor began as an obscure mechanism by which the cash managers at London banks agreed on the rate at which they thought they could lend each other money over short periods of time. The only reason that Libor became as important as it did was because of London’s role as an offshore market. In the 1970s, US banks were constrained by rules on deposit rates, and with the boom in middle-Eastern oil, a market in ‘offshore dollars’ grew up in the City. As a benchmark for the short-term rate on dollar lending, Libor was pressed into service.
If things had remained as a purely cash-based market, Libor might have stayed in obscurity – an innocuous benchmark that never actually traded. However, the trading soon began in derivatives, firstly in 1981 with the Chicago Mercantile Exchange’s Eurodollar futures contract. That allowed traders to bet on three-month dollar Libor ‘fixings’. The CME future was then eclipsed over the following two decades with over-the-counter interest rate swaps, options and more exotic derivative contracts that all had Libor built into them and grew into a market hundreds of trillions in size.
Unlike futures, OTC derivatives are dominated by a handful of large banks, including Barclays. Unlike futures that are margined daily and reported to the exchange, these derivatives are mostly transacted in private and stay on the bank balance sheet. In the years before 2007, Libor became a sort of plasma in which the blood cells of derivatives flowed, yet all the time kept its archaic cash-based fixing mechanism. Given the derivative trillions at stake, it would have been surprising if the banks involved in fixing the rate had not started rigging it at some point.
As the FSA notice on Barclays shows, the contradictions within Libor really became obvious in 2007 when the pretence that it was risk-free became untenable, and investors began watching it as an indication of bank health. Today, Libor has all its lights on but no-one is at home ““ after all, who wants to lend to an international bank on an unsecured basis these days? Even the derivatives industry is abandoning Libor as fast as it can, with pricing now based explicitly on cost of funding and collateral.
Whatever new standard ends up being adopted, the Libor scandal is a grave threat to the reputation and credibility of London as a financial centre. After all, why should American mortgage borrowers, Asian money market funds and European corporations ever trust again a cartel of casino operators (sorry, London-based banks) as a source for their short-term borrowing and investing benchmarks?
Q: How did swap mis-selling by UK banks become such a problem and is it being addressed in the right way?
A: British small business and retail lending didn’t used to be like this. Banks might offer a range of different loan products – floating rate, fixed rate, capped etc – and if a customer needed to repay a loan early, an early redemption fee would be applied that would be capped at a few per cent of the value of the loan. That practice – and the quite reasonable assumption by customers that it hadn’t changed -played a big part in this scandal.
What changed in banking mirrored the transmogrification of Libor. The global interest rate derivatives business – rates trading – became more profitable than retail banking. As I described in The Devil’s Derivatives, the ‘men who love to win’, the Bollinger-drinking characters you meet in the Barclays Libor emails, took over the system.
Saddled with astronomical infrastructure and bonus costs, this rates trading beast needed feeding. The small and mid-sized business customers of middle England were offered up on this altar. Loan products became derivative-based in the name of risk management, with the largest profit component booked by the trading desk at the time of the loan, and the risk being hedged out in the market. Unbeknown to the customer, they were now sitting at a roulette table, and when rates plunged in the wake of the crisis, the croupier scooped up the chips and the customer paid the price
Connecting less-sophisticated clients to the trading casino for quick profit is an old trick of investment banks. As I documented in my book, JP Morgan, Deutsche Bank, Barclays and others were repeatedly accused by clients of such arbitrage in continental Europe over the last 15 years while hiding behind the ‘caveat emptor’ legal protections of UK civil law. But the sheer self-defeating idiocy of British banks treating the least-sophisticated layer of their home constituency in this way is astonishing. At least they have helpfully woken up the British public to the dodgier practices of the industry nurtured by the City for so long.
So what of the solution? The FSA settlement bans the worst products and commits the big four offending banks to some kind of restitution. Recent UK government proposals attempt to ring-fence trading businesses from traditional banking, while permitting derivatives to be sold to them. Neither step goes far enough. We need to cut the link between small business or retail lending and the trading casino. If banks want to sell loan products with fixed rates and other features, they should cap early redemption costs and manage the interest rate risks on their customers’ behalf. That requires ‘asset-liability management’ (ALM) and might involve a treasury desk trading derivatives and a tough risk management department – which takes us to our last question.
Q: What are the lessons of the ‘London Whale’ losses at JP Morgan in terms of regulating proprietary trading and the structure of banks?
A: ALM, the activity that is supposed to insulate bank customers and shareholders from swings in interest rates and other market moves, was ostensibly one of the functions of Ina Drew’s chief investment office at JP Morgan. Somehow, this fairly humdrum purpose morphed into the betting on credit default swap indices that lost $2 billion in April and probably three times that amount since as JP Morgan unwinds the trades. As with Libor rigging and swap mis-selling, the London derivatives playground had a central role.
The JP Morgan unit had plenty of excess cash – over $300 billion – and this size had a corrupting influence on the bank as it led the CIO traders to believe that this muscle could create self-fulfilling prophecies. By definition such units should only be taking credit risk for short periods – three months or so – leaving longer-term credit risk-taking to the core lending functions of the bank.
The unit violated that principle by filling its boots with mortgage-backed and other investment grade securities that it snapped up at distressed levels in the market, apparently with the approval of Jamie Dimon. According to Dimon’s testimony to the House Financial Services committee on June 19, the impact of Basel banking rules prompted a re-think. “We instructed CIO to reduce risk-weighted assets and associated risk”, he said.
Instead of selling its securities at a profit, Basel permitted the CIO unit to cancel out its exposure using credit default swaps. Combine that with a team imbued with a London-bred culture for credit derivative trading, and the CIO unit carried out its ‘instructions’ by entering into complex correlation and credit term structure positions that should rightfully have belonged within a hedge fund.
Where does this leave the Volcker Rule? No doubt, the regulators charged with implementing it will add some rider to the effect of banning US banks from operating their treasury units like internal hedge funds. But as Dimon seemed to imply, does Basel-motivated hedging trump Volcker? How easy it is to tell the difference?
The scandal adds to the perception that the Volcker Rule amounts to an impossible attempt to square the circle. By permitting deposit-insured US banks to run derivatives market-making operations, regulators have committed themselves to catching proprietary trading violations as they happen. Yet, any market-making business has to involve some proprietary trading as it warehouses and matches up client trades.
Wouldn’t it have been simpler to have separated market-making and investment banking generally from deposit-insured banking? By failing to grasp this nettle, US regulators have almost pledged that they will fail.
To use a parable: the Glass-Steagall Act had a daughter, the Gramm-Leach-Bliley act, which was impregnated by bankers and produced another child, the Volcker Rule. In well-meaning reverence to its bloodline, US Congress has elevated this somewhat debased progeny into playing the role of its grandfather. A lesson from the last week is that there’s no substitute for the real thing.
