The Deep Libor Lesson

Written by Thomas Donaldson

As the carnage from the Libor scandal mounts, the deeper meaning of the scandal is being missed. We are in search of the “usual suspects,” e.g., poor compliance, poor leadership, and lax government regulation, even as a more subtle and darker problem lurks in the background. However, better compliance, better leadership and even more rigorous regulation might not have prevented the Libor scandal.

“Libor,” acronym for the London Interbank Offered Rate, is meant to reflect the rate at which the biggest banks believe that they can borrow money from a fellow bank. Libor was established in the 1980s during a period when banks often did in fact borrow money from other banks at such rates. It is used to set other rates attached to many loans and transactions, such as short-term business loans, money market funds and shortterm bond funds. Because Libor drives so many other common rates, the outcry was loud when in 2012 the UK’s Barclay’s Bank was charged with rigging the Libor rate. If Libor had been rigged, then it meant that other rates had also been rigged, rates that affected trillions of dollars of transactions annually. The very efficiency of financial markets depends on markets being able to observe the true level of benchmark rates.

Soon after the revelations, both Barclay’s Chairman and also its CEO, Bob Diamond, left their positions, and emails from Barclay’s traders were published in the financial news. The messages were damning. One, from a derivative trader, stated blatantly that “we need a really low 3m fix.” Soon after, not only Barclay’s Bank, but other banks were alleged to have rigged Libor, and another CEO, Piet Moerland of Rabobank, stepped down. By mid-December, 2013, UK authorities had reached settlements with five banking institutions, even as additional fines for many other companies and individuals were expected in the future.

Given the significance and impact of the Libor scandal, we must ask the obvious question: “Who or what was responsible?” There are plenty of suspects. To begin with, leadership at the banks was probably less than optimal. Some managers at Barclay’s appear to have been aware of the Libor lowballing practices, even before a call from an official at the Bank of England referenced Libor rates. The CEO, Bob Diamond, had a history of questionable enforcement of rules, and in 1999 traders under his supervision at BarCap broke rules that led to large financial losses. In addition to poor leadership, poor culture is implicated. For many firms charged in the Libor mess, their cultures almost seemed to encourage abuse of Libor-setting rules. Manipulation was played out in the open, not in secret, and employees felt pressure to comply. Barclay’s leaders complained out loud about the competitive advantages that accrued to the Libor setting practices at rival banks without any seeming awareness of how such complaints might pressure lower-level Barclay’s employees to follow suit.

Finally, compliance and lax government regulation are implicated. The FSA (the UK “Financial Services Authority”) in its investigation of Barclay’s noted that the issue of rate fixing had been escalated to the compliance group on more than one occasion during the period 2007-2008, but that the compliance group failed to follow up. The very definition of the Libor rate was opaque, and the New York Federal Reserve Bank had complained prior to the scandal that banks were being asked to compile rates without clear guidelines.

But even as we move to lay blame at the usual doorsteps, that is, failed compliance, leadership, culture and poor regulation, one piece of the Libor puzzle is missing. It is what my colleague Paul Schoemaker and I have referred to as “systemic industry-level risk,” and what I have called in another writing the “normalization of questionable behavior.” Authorities now believe that the Libor fraud occurred at an industry, not a firm, level. It was carried out by scores of traders, working at multiple firms around the globe in offices scattered in places such as Utrecht, Tokyo, Singapore, Frankfurt, Hong Kong and London. What is special about industry-level systemic issues is how they tend to elude single corporate ethics and risk-control mechanisms. When bad practices become institutionalized at an industry level, they become “normalized,” meaning that participants undertaking the questionable practices become numb to their moral significance. When attempting to confront such systemic industrylevel practices, single-company compliance mechanisms and other risk-avoidance strategies, even when accompanied by good single-company cultures and firm leadership, are forced to play a new game, a game often out of their league. In big league, industry- level struggles, the single firm can be a too-small David confronting an unkillable Goliath.

To understand this phenomenon better, recall the subprime, securitized mortgage debacle. For any single financial firm to have abandoned the big rewards promised by the utilization of securitized, subprime mortgages would have placed it at a large, short-term disadvantage in a highly competitive industry. As Chuck Prince remarked, ‘‘As long as the music is playing, you’ve got to get up and dance.’’ For Libor rate setting, too, the music was playing. And at the Libor party, everyone had been dancing for a long time. Staying off the dance floor was regarded by traders as financially costly, and in the short term, they were probably right. Moreover, while each firm should have resisted the siren call of the industry, the phenomenon of the “normalization” of questionable behavior made it difficult for individual firms and traders to see the true significance of the problem.

Of course, readers may respond that it is in precisely such instances that the government must serve as the final safety net. Indeed, this is supposed to be the function of regulation: to manage both company and industry-level behavior. But as I have shown elsewhere, effective industry- level regulation of “normalized” behavior is especially difficult when industry players are more knowledgeable than regulators, something not uncommon in the complex world of financial transactions. Such regulation is also difficult when the regulators and industry players themselves enjoy a cozy relationship, a relationship sometimes referred to in the sociological literature as “industry capture.”

Libor-style problems extend beyond the banking industry; as Paul Schoemaker and I have shown, they have arisen in many industries, including energy, pharmaceuticals, and accounting. The hope for avoiding the special kind of problem reflected in the Libor scandal can only lie at the level of the industry itself with the use of what we have called “Pelican’s Gambits.” A Pelican’s Gambit is defined as a strategic move towards cooperation in a highly competitive environment that limits systemic risk to the firm, industry and society. Industries, galvanized by influential industry leaders, must sometimes sacrifice the rule of competition in order to adopt a cooperative strategy that limits risk to the industry and to society. In the instance of Libor, the banking industry itself should have detected and managed the Libor rigging practices long before the scandal exploded and damaged both the industry and society. It is this, the need for cooperative, industry-level identification of “normalized” questionable behavior, then, not only in banking but elsewhere, that constitutes the deeper meaning of the Libor scandal.

Author Biography

Thomas Donaldson is The Mark O. Winkelman Professor of Legal Studies and Business Ethics at the Wharton School at the University of Pennsylvania, focusing on ethics, corporate compliance, corporate governance and leadership.