© Hersh Shefrin
|
Hersh Shefrin
Professor of Finance at Santa Clara University
Regulators worldwide are conducting a criminal investigation into possible manipulation of Libor rate. The world's biggest banks such as Citigroup, Deutsche Bank, HSBC, Royal bank of Scotland and UBS are under suspicion of intentionally suppressing the interest rate. In light of the overhaul, the British Banker's Association (BBA) is considering either an improvement of Libor rates setting process, or new regulatory control and compliance requirements for banks in Libor panel.
Dukascopy is carrying out a research to evaluate the current Libor-setting system, find out whether new measures proposed by the BBA can combat the potential future manipulations. The bank interviewed H. Shefrin, Professor of Finance at Santa Clara University and author of numerous books on behavioural finance.
How would you evaluate the current Libor-setting process? How can it be improved?
There are two issues here. First, in the language of game theory, the current Libor-setting process is not incentive compatible, meaning that participating firms do not have inducements to communicate truthfully. Second, in the language of Adam Smith, the firms in competitive markets have an incentive to fix prices. Smith 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. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice." Both of these issues prevent the emergence of "first best" outcomes, and so we must accept the second best. Heretofore, the general, but mistaken, assumption is that the Libor setting process has been first best.
Improvement requires the introduction of second best techniques normally associated with incentive issues and price fixing, namely oversight, a cost (penalty) structure, and anti-trust provisions. Of course, these create distortions themselves, and so the challenge will be to choose the lesser of competing evils.
Will the new measures considered by the BBA, namely a revamp of how Libor rates are set and new regulatory control and compliance requirements for the banks, be effective to prevent future manipulation?
One would be overconfident to think that the problem will disappear in the long run. However, there is reason to think that current public attention will improve matters in the short run.
If it reveals that the banks are guilty for illegal speculation, namely setting significantly lower interest rates, what consequences there might be for the banks? How the financial instruments, which use Libor as a reference rate, might be affected?
For banks, the costs will be penalties and significant legal fees, more reputational damage, and stronger regulatory oversight. As to Libor, a lot depends on what the next best alternative is to using Libor. Libor rate may continue to be used as the basis for financial contracts, but perhaps be supplemented with other variables.