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Abstract

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

The recent rate-rigging scandals serve as a reminder that capital markets need to be properly regulated.

The liberalization of global and external capital markets has provided the impetus and justification to deregulate national capital markets.

The need and concern for increased regulation of bond and equity markets, as well as other complex financial instruments which can be traded ‘over the counter’ in the derivatives markets, is evidenced by Basel III's focus.

‘Cartelization’ and organized activities in global capital markets have been evidenced recently by sophisticated EURIBOR and LIBOR rate-rigging practices and occurrences.

Introduction

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

Pressures for the deregulation of national capital markets have increased over the years in response to global liberalization processes. The differences in the levels and extents of regulation of capital controls that operate within national borders have affected in various ways the competitive positions of banks in external markets.

The growth in international financial markets is due only in part to multiplier mechanisms. Some basic characteristics of offshore contexts — such as the Eurodollar market, featuring freedom from national regulations and international scope and dimension — have also contributed significantly to the popularity and attractiveness for investors. Indeed, a huge quantity of resources has migrated from onshore to offshore destinations notwithstanding the associated additional risks in taxes, various difficulties in accessing those particular markets, as well as inconveniences arising from foreign deposits.

The developments that have dominated the liberalization of financial markets stem from the rise of the Eurocurrency markets in the 1960s and the subsequent shift from banks to portfolio investment in the 1980s. As D'Arista (2002, p. 77) has effectively pointed out:

The waves of capital flows into the United States, and subsequently into Germany, Switzerland, and other European countries in the late 1960s and early 1970s, demonstrate how effectively the Eurocurrency markets are able to circumvent capital controls by making it possible for participants to change the currency denomination of loans and investments outside national markets in response to changes in interest rates, and subsequently (to) changes in exchange rates.

The Eurocurrency markets have not only facilitated the undermining of regulatory strategies given their ability to circumvent national capital controls and regulations, but also hindered the central banks' ability to implement monetary policies effectively. A further and more lethal consequence has also emerged over the years: the rigging of the London Inter-Bank Offered Rate (LIBOR) and Euro Inter-Bank Offered Rate (EURIBOR).

Definitions

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

LIBOR is described as ‘the benchmark interest rate that underpins trillions of loans, credit cards, mortgages and derivatives around the world’ (Merco Press, 2012), while EURIBOR is also considered of vital significance given its role in setting borrowing rates for trillions worth of mortgages, loans, and credit cards. Philipponnat (2012) has noted

LIBOR and EURIBOR have different definitions, which makes the possibility of rate rigging different. However, they have one feature in common: they are calculated from contributions with in-built conflicts of interest and this characteristic is not compatible with the ambition of rebuilding integrity and trust in our financial system.2

While LIBOR is considered to ‘reflect the cost of borrowing of the contributing bank,’ EURIBOR ‘reflects the contributing bank's conviction about the cost at which a prime bank (i.e., not necessarily the contributing bank itself) would offer term deposits to another prime bank’ (Philipponnat, 2012). Furthermore, LIBOR is ‘the average rate at which a leading bank can obtain unsecured funding in the London interbank market for a given period, in a given currency’ (Treasury Today, 2012).3 The ways whereby corporations are exposed to the two rates include borrowing and their use as reference rates in many derivative products and swaps. At present, LIBOR and EURIBOR have, respectively, 18 and 44 contributing banks.

Self-regulation

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

The self-regulatory nature of LIBOR is illustrated by the fact that ‘it is not only currently presided over by the British Bankers' Association (BBA), a private banking trade and lobby group,’ but also indirectly by 18 of the world's largest banks, ‘which submit loan data to the Libor board every morning to help set the global rate to which their own trading bets are tied’ and control, at the same time, the BBA itself.

As a result of the self-regulatory nature of LIBOR, regulatory capture not only constitutes the inevitable consequence but also the frequent occurrence of practices attributed to a system void of adequate levels of accountability and transparency, as well as one embroiled in associated corrupt practices and conflicts of interest. Lack of accountability facilitates an environment whereby high degrees of conflict of interest are encouraged. It also facilitates incidences involving the ‘passing of the buck’, which results in an inability to identify and bring to book the principal offenders. Several sources contend that the rigging of LIBOR and EURIBOR scandals commenced as far back as 2005, culminating during the last worldwide financial crisis. Even though concerns and suspicions of rate-rigging practices had been raised as far back as 2007, these expressed concerns remained unheard and the rate rigging has escalated to the levels that presently persist.

As stated by Philipponnat (2012):

Benchmarks with a large public impact should not be left purely to private interests. The idea of ‘effective self-regulation’ has proven over and over again to be an oxymoron in financial services and is not the way to restore the public's profoundly shaken trust in the fairness of financial activities.

Recent discoveries not only reveal that a group of international banks have been manipulating interest rates for years (see, for example, Böll et al., 2012), but also point to the even more serious fact that some banks involved in the cartelization process are those responsible for setting and calculating the LIBOR rates. Whilst two traders have recently been made scapegoats for the regulatory failures and gaps in the rate-rigging process,4 it is becoming more likely that other participants in the rate rigging (bankers included) will be placed under pressure to disclose their involvements in the cartelization process.

Recent measures and proposals

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

LIBOR's fixing imposes more requirements than that of EURIBOR, whereas the number of banks contributing to the EURIBOR determination makes it less likely for manipulating practices to occur. Greater accountability will be achieved if the number of banks contributing to the determination of LIBOR rates increases. Greater consistency can be achieved with the definitions of the two reference rates by basing them on effective financial rates, whilst more accountability can also be fostered by making banks, managers, and operators individually and collectively responsible for their actions.5 Furthermore, external regulatory oversight of benchmark setting, as well as greater use of transaction data, has been put forward (Finance Watch, 2012).

The impact of LIBOR and EURIBOR on millions of lives was clearly illustrated in the interpretation of Grey (2012):

The daily Libor rate, which is supposed to measure the average cost of short-term loans between major banks, determines the interest rates for loans and investments that affect hundreds of millions of people around the world. Libor and Euribor are used to set the borrowing rates for $10 trillion in mortgages, student loans and credit cards. Some 90 percent of US commercial and mortgage loans are said to be linked to the index. Libor influences an estimated $360 trillion of loans and credit default swaps. It impacts futures contracts traded on the Chicago Mercantile Exchange with a notational value of more than $564 trillion.

It would therefore not only be in the public's interest, but also in the interest of global and economic stability (and a means of restoring the credibility of the LIBOR and EURIBOR rates on which many investors and markets rely), if measures and reforms aimed at addressing the rate-rigging practices could be implemented effectively.

Monetary setting policies

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

The impacts of Eurocurrency markets on monetary setting policies and banks' competitive positions have also been highlighted. How can regulation be implemented effectively to ensure that it is not too rigid (such as to place banks at competitively disadvantaged positions in external markets) while not being too lax (such that effective monitoring, compliance, and enforcement mechanisms are impeded)?

In addressing the issue of monetary policy setting, the challenges faced by the US Federal Reserve embrace the admission that current fiscal and monetary policies in the USA are not feasible, as well as the argument that the Federal Reserve's range of powers is too wide.6 The Federal Reserve is considered to have a role that encroaches and interferes with that of legislature and the executive — particularly in job creation issues that could impede the pace of achievement of fiscal policy objectives. Several reforms have been proposed (Basel Committee on Banking Supervision, 2012) of the BIRS (Financial Executives International, 2012). They include the following:

  • i
    The Fed's dual mandate for monetary policy should be eliminated. While it is clearly important for national economic policy to be designed to achieve ‘full employment,’ which varies over time based on domestic and global conditions, and to keep unemployment and underemployment as low as possible, this should not be the Federal Reserve's job.
  • ii
    The Fed's monetary policy should be that of promoting relatively stable prices and reasonable long-term interest rates. By doing so, it can help create an economic environment that will facilitate economic growth and job creation.
  • iii
    Instead of the Fed, the US Congress and the President should be working together to address the many structural and sustainability challenges that directly affect economic growth and job creation.

Even though it is further added that while ‘the Fed needs to provide reasonable transparency regarding its decisions on monetary policy, after those decisions have been made,’ it is also mentioned that ‘it should be able to conduct its research and deliberations on monetary policy without being subject to audit, in order to facilitate sound and non-political decision-making.’ After the LIBOR and EURIBOR scandals, should the Fed be exempt from audit? Indeed, should any federal regulator or supervisor be exempt from audit?

Melvyn King, the former Governor of the Bank of England, made a significant reference to the independence of the central bank in the UK. He declared: ‘How much discretion to give to the Monetary Policy Committee and how much should remain with the Chancellor is an interesting question that was raised, but not fully resolved, in 1997,’ referring to the date when the Bank gained operational independence (Reuters, 2013).

However, despite the emphasis on central bank independence, a lack of absolute independence (from political spheres) could prove symbiotic in the sense that, despite the need for a certain degree of independence from political interference, certain events which are capable of devastating consequences need to be responded to as promptly as possible. Furthermore, subjecting actions and decisions of the central bank to other authorities should actually incorporate greater accountability and transparency into the supervisory and regulatory framework.

Conclusion

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

In the wake of the EURIBOR and LIBOR rigging scandals, the British Bankers' Association (BBA) in September 2012 indicated its willingness to give up its role in setting LIBOR rates. Whether such a role should be assigned to another body does not constitute the crucial issue, since the new authority could still be controlled or influenced by the 18 contributing banks which submit loan data to the LIBOR board every morning, as well as help set the global rate to which their own trading bets are tied. In other words, the system of self-regulation that currently governs the BBA's operations as well as EURIBOR procedures urgently needs to be reviewed.

Furthermore, bank regulators and banks need to be engaged on a greater level (than at present) in the calculations of LIBOR and EURIBOR rates, rather than the process of merely designating the benchmark rate determination to money market traders. Such traders are considered to exhibit higher tendencies for conflict of interest.

While penalties and fines have been imposed on those banks involved in the recent ‘cartelization’ and rate-rigging scandals, the cost of rate rigging (inclusive of the costs for tax payers) is considered to be proportionately high relatively to those fines. Furthermore, the passiveness and indifference of many national regulators and supervisors to rate-rigging suspicions and practices constitutes a cause for concern. Greater accountability and responsibility would need to embrace the involvement of national regulators and supervisors. While the free market is considered by some to be capable of regulating itself and evolving with technological and global developments, some form of policing in the form of adequately balanced regulation is required to ensure that market participants do not exploit those opportunities arising from gaps in the regulatory and supervisory process.

The predecessors to the Basel III agreements were often criticized for their failure to address system-wide risks. It is therefore commendable that Basel III places some degree of focus on such risks. The use of external auditors should also serve as a means of incorporating increased checks and accountability into the regulatory process. The transfer of supervisory powers back to the Bank of England in July 2013 should, hopefully, signify an era which introduces (or rather reintroduces) greater implementation of external auditors' expertise in contrast to the reduced level of use of external auditors by its predecessor, the Financial Services Authority.

The recent rate-rigging scandals serve as reminders that externalities occur within capital markets. Perfect markets do not exist and, even though markets are constantly evolving, too much belief in their efficiency could actually result in undermining and hindering the quest for optimally effective regulatory measures.

  • 2

    Philipponnat (2012) adds that the different definitions of EURIBOR and LIBOR rates reflect the fact that they were established by different private bodies pursuing different and often competing interests.

  • 3

    It is also to be noted that ‘it is a lending (offer) rate, not a deposit (bid) rate, and is calculated by averaging the middle two quartiles of the rates submitted on a daily basis by a panel of 16 banks to the BBA (British Banking Association). The top and bottom quartiles are discarded’ (Treasury Today, 2012).

  • 4

    The Swiss Competition Commission has recently declared: ‘Derivatives traders are also believed to have agreed upon the difference between the buy and sell prices (spreads) of derivatives, thereby selling these financial instruments to customers under conditions that were not customary in the market.’

  • 5

    As well as making contributions reflect financial reality, basing LIBOR and EURIBOR on effective rates is also said to narrow the avenues whereby rate manipulation could occur.

  • 6

    Compare this vision with that of the intended European Monetary Union Framework outlined by Praet (2012), a member of the executive board of the ECB: ‘On the central bank side, the maintenance of price stability over the medium-term is the most important contribution that monetary policy can make to sustainable growth, employment, and social cohesion. On the fiscal side, the institutional framework reflects our long-standing experience that sound and sustainable fiscal policies are in turn fundamental to fostering longer-term sustainable economic growth. Following these principles, monetary and fiscal policies are mutually re-enforcing. Solid fiscal policy is conducive to a macroeconomic environment that facilitates the task of a stability-oriented central bank. At the same time, credible monetary policy contributes to a smooth conduct of fiscal policies by guaranteeing stable inflation expectations and low inflation risk premia, which is in turn beneficial for the level and volatility of long-term government bond yields and therewith sovereign financing costs.’

References

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

Biographical Information

  1. Top of page
  2. Abstract
  3. Introduction
  4. Definitions
  5. Self-regulation
  6. Recent measures and proposals
  7. Monetary setting policies
  8. Conclusion
  9. References
  10. Biographical Information

Marianne Ojo is a Professor with the Faculty of Commerce and Administration, School of Economic and Decision Sciences, North-West University, South Africa. She is a postdoctoral researcher at the Legal Scholarship Network, as well as a university lecturer at Covenant University and a visiting scholar at the University of Heidelberg.