As it happened, when the Libor story began to break two weeks ago, I was reading Joel Mokyr on the institutional underpinnings of the Industrial Revolution. Mokyr, of Northwestern and Tel Aviv universities, is the foremost living historian of that momentous transformation, the author of The Enlightened Economy: A History of Britain 1700-1850 (as well as the earlier The Lever of Riches: Technological Creativity and Economic Progress; and The Gifts of Athena: Historical Origins of the Knowledge Economy).
In the essay I was reading, a contribution to Institutions and Economic Performance, a conference volume, Mokyr zeroed in on a question underlying the current controversy in which one of the world’s most important interest rates was manipulated in some small degree during the crisis of 2008, both for the preservation of civilization (by regulators) and for private profit (by traders) – How did London get to be the way it is?
Useful background, presumably, for thinking about a harder question: What way is London now?
It’s been an article of faith for thirty years among economists of a certain sort (new institutional economists, they call themselves) that British success stemmed from the Glorious Revolution of 1688 – more broadly, that political developments in the seventeenth century set the stage for the rise of Britain as a world power in the eighteenth.
How so? In the aftermath of the English Civil War, suspicions lingered among between Protestants and Catholics, English and French. To tamp them down – and to assure that Catholicism would not return to Britain as a state religion – the British monarchy (and its extensive bureaucracy) and Parliament cut a deal: each surrendered some power to the other, creating a credibly divided and financially responsible government, thereby permitting “a grand coalition of merchants and landowners [to emerge], keen on protecting commerce and property.” The modern legal system followed in due course, along with intellectual property rights, regulators, transportation infrastructure, schools and universities, all that is summed up in the present-day catchphrase, “the rule of law.” To make a modern state, add mixture as before. Or so the story goes.
Maybe, but Mokyr was at pains to say that the importance of formal institutions has been overemphasized, at the expense of cultural beliefs and the informal institutions that they brought forth. These “private order” institutions fostered trust, enabled inventors and entrepreneurs to operate and cooperate, and permitted markets to function relatively smoothly. Informal codes of conduct, religious moralizing, and local reputation effects seems to have led to better conduct and increased private settlement of disputes. A French visitor to London in 1824 wondered how a city of a million people, twice the size of Paris, could keep order with as few constables and watchmen as it seemed. Social norms and private institutions paved the way.
Which brings us to the present day. One such trust organization is the British Bankers’ Association. Another is Barclays, an old Quaker bank which traces its roots to 1690.
Libor, the London Interbank Offer Rate, originated only in 1986. That was the year the “Big Bang” deregulated financial services in the United Kingdom along the lines initiated eleven years before by “Mayday” in the United States. The idea was to eliminate haggling. Libor was a perceived rate, not a record of actual transactions: the idea was to ask fifteen blue-chip banks for their best guess daily of what it would cost them to borrow, throw out high and low, and use the benchmark to mark up riskier loans accordingly.
Luster was restored to British banking in due course. Libor became an international standard, a recipe for reality something like Greenwich Mean Time – except there was no carefully attended chronometer, much less an atomic clock – just the word, once a day, of fifteen increasingly global banks. Some $10 trillion in loans are based on it, in ten currencies, reflecting fifteen maturities — everything from overnight corporate deposits to credit cards to thirty-year mortgage loans – not to mention the derivative securities that are based on them.
In the crisis, Libor “became a measure of something else,” as Paul Tucker, deputy governor of the bank of England put it in his testimony to Parliament – the solvency of the banks themselves. Measured against an index of overnight interest rate derivative contracts, the Libor-Overnight Indexed Swap rate spread became a measure of the difficulty major banks were having attracting funds. No wonder, then, that British banking authorities apparently sought, at least at one point or another in the run-up to the panic itself, to homogenize reported rates on the low side.
If that were all, the Libor scandal would be just another hard-to-follow episode in the annals of central banking. But it’s not. Traders for Barclays were enlisting the bank’s internal regulators to shade the bank’s reported rates, cheating the counterparties in various deals when reported Libor rates turned out to be higher or lower than expected. Those emails are the clincher. “Always happy to help,” one rate-setter emailed a trader. “For you, anything, big boy,” wrote another. Barclays was merely the first to settle with authorities and pay a whopping fine. Now it faces civil suits for damages. Several more banks are under investigation.
And just today, Ben Protess and Mark Scott of The New York Times reported that the US Justice Department is building criminal cases against several banks and their traders, including Barclays. UBS is among then next targets of a civil investigation; the Swiss bank is cooperating with one branch of the Justice Department in exchange for a promise of immunity from criminal prosecution. the reporters learned. The complex investigation may continue for several years, they added, and likely will sometimes pit US regulators against their British counterparts.
Except for the money, the Libor controversy bears some resemblance to the phone-hacking scandal that forced press baron Rupert Murdoch to shut down his News of the World and cost him a chance to tighten his grip on British politics through the purchase of a satellite broadcaster. In that case, too, private-order institutions of various sorts that had emerged over the years to foster trust and facilitate commerce – long-standing relationships among police, politicians and members of the press – were perverted by one set of players to the disadvantage of others. The difference is that in manipulating UK politicians, Murdoch didn’t reach into pockets around the world.
In a cover story two weeks ago, The Economist described London’s “precarious brilliance” as resting on the nation’s acceptance of an alliance of bankers, immigrants and the rich, those upon whom the success of its capital depends. It was a sly way of posing the problem without actually stating it – the British countryside has always viewed its cities as moral cesspits. And indeed, London, left to its own devices, would resemble Rome – more than a little too inbred to be trusted.
But then London has New York and Washington to keep it honest (the Libor scandal emerged from an investigation by the Commodity Futures Trading Commission), just as US bankers and regulators have London to keep them smart. New approaches to the problems of the financial services have a way of emerging from Mayfair and Threadneedle Street.
Meanwhile, this much is clear: the banking industry needs a new rate-setting system, one based on transaction prices. Mervyn King, governor of the Bank of England, said as much the other day: “The idea that My Word is My Libor is dead.” But then rate setting is comparatively easy; engineering systemic trust is hard. What might successful codes of conduct look like nowadays? I am searching Capital, John Lanchester’s novel about modern London, for clues.