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Manipulation by Design

While central planning for the economy has failed completely, will centrally-planned monetary systems follow

Barclay’s CEO, Bob Diamond, recently lost his job. In the aftermath of the financial crisis in 2008, Tucker, Deputy Governor of the Bank of England (BoE), telephoned Diamond. Tucker, apparently, indicated that Barclay’s Libor rate “did not always need to be as high as (they) have (been) recently”. Diamond passed on the message to his team — who took this as indication from the BoE to report lower rates — which they proceeded to do. Investigations of this “rigging” have so far led to resignations of the Chairman, CEO and COO of Barclays. Barclays has been fined £290 million for this attempted “manipulation”.

Can’t “fix” rates on your own
The Libor is calculated (fixed) by Thomson Reuters on behalf of the British Bankers’ Association by taking a poll of a panel of banks (16 banks for pound, 18 for USD) just prior to 11 AM. The survey asks banks the rates at which they “think” they can borrow. No actual transaction takes place. It is at best an “oligopolistic” rate — a “survey” rate. The four lowest and four highest rates are then eliminated and the Libor is calculated by taking an average of the rest. If Barclays was consistently reporting higher rates than the rest, it would have been eliminated. Even an “in sample” bank will have a weight of about 10 per cent. Overall, any single bank can skew the rate only by a few basis points (1/100th of a per cent) at best.
In markets where money moves freely across borders, rates in one currency cannot dramatically differ across borders. One way to check if the Libor was completely out of whack is to check its correlation with the T-bills rate in the US — the rate at which the US government borrows. The US T-bill rate in turn tracks the Fed Fund rate — a rate which the US Federal Reserve “manages” by intervention in the money markets (which includes printing dollars when needed). As the graph on the next page shows, barring the spike in 2008 (caused more by liquidity tightening post Lehman), there seems to be no systematic drift in the value of Libor vs T-bills.

The elephant in the room
Policy statements of Central Banks are watched carefully — for one primary reason. As the monopolistic printer of money, the Central Bank in any economy is in the business of managing (manipulating) interest rates. It is what they do. It is their mandate.
In 2008, a sharp fall in housing prices — caused in no small measure by the US Fed allowing an asset price bubble to be formed, led central banks the world over to lower interest rates. This increased asset prices, thereby shoring up the balance sheets of banks. This was manipulation — as is all policy “intervention” by Central Banks. In that context, Barclays executives cannot be faulted for doing what they thought their regulator wanted them to do. It seems strange logic that the bank is being penalised for working on the directions of the Bank of England.

Banks — more equal than others
In a recent interview to Business Line, Dr YV Reddy, the former Governor of the Reserve Bank of India, is quoted as having said, “The government licenses banks to accept non-collateralised deposits — virtually telling people that your deposits are safe. The banks, in turn, agree to lend to government whenever the government wants. This is a compact. In some sense, it is the biggest con game going on”. The implied sovereign guarantee allows banks to leverage their balance sheet 10 times, magnifying the return on equity. The heightened risk is mitigated by the back-stop of the central bank. This sets up moral hazards. Bankers get incentivised for taking risks — if the risks materialise, the Central Bank steps in. Else, bankers receive outsize bonuses on profits from highly leveraged transactions.
Central Banks were set up with the objective to bring stability to the monetary system. In reality however, their intervention has led to increased volatility and boom and bust cycles. When the banks involved are “too big to fail”, the problem becomes that of the tax payers.

Unintended consequences
The power to manipulate markets is not easily controlled. Borrowers — corporations and consumers (home loans and consumption loans) — lobby central banks for lower rates irrespective of the economic situation. When was the last you heard a demand for higher interest rates when the economy was over-heating? However, when growth slows, the clamour for lower rates rapidly rises.
Lobbying also ensures that shareholders are not penalised. In 2008 public money was liberally used to bail out banks in the US — directly through investment, and indirectly through monetary policy. The ownership of stressed banks and financial institutions remains with the original owners — a situation where profits are private and losses are public! Central planning for the economy has failed. Will centrally-planned monetary systems follow?