London Self-Regulatory System Proves Illusory in Libor Scandal

As long ago as June 2008, New York Federal Reserve President Timothy F. Geithner was warning the Bank of England that letting bankers set the benchmark interest rate for global finance was open to abuse.

Governor Mervyn King’s failure then to take greater responsibility for Libor now poses a new threat to London’s drive to rival New York in the battle for a larger share of a shrinking international financial industry.

“As a company, we now avoid London,” said David Kotok, who manages about $2 billion as chief investment officer at Cumberland Advisors Inc. in Sarasota, Florida. “It’s tarnished. Passing the buck to others, shirking responsibility and avoiding accountability characterizes the people at work there.”

Not only has the scandal dealt another blow to the self-regulatory model that was the hallmark of Britain’s longest stretch of growth for 200 years, it is throwing into question Prime Minister David Cameron’s plan to put the Bank of England in primary charge of banking regulation.

The financial-services industry faces “a crisis of trust and reputation” after years of light-touch oversight created a culture of “cynical greed” laid bare by the Libor crisis, Adair Turner, current chairman of the U.K. Financial Services Authority, said July 3.

Second Week

Bank of England officials may now face a second week of grilling by lawmakers on whether they did enough to stamp out manipulation of the London interbank offered rate, the benchmark for $360 trillion of securities. About a dozen banks are under investigation for rigging the rate, with Barclays Plc already paying a record fine and ousting its top three executives. Turner and deputy governor Paul Tucker will tomorrow join King to testify on the bank’s latest Financial Stability report.

The U.K. central bank has so far defended itself by saying it thought the system was dysfunctional rather than dishonest and that it lacked the powers to effect change. Geithner, now the U.S. Treasury secretary, nevertheless put its officials back on the defensive at the end of last week with the release of a 2008 memo listing ways to make Libor more transparent.

Among the advice given, Geithner sought new procedures to “prevent accidental or deliberate misreporting” of Libor. While King called the recommendations “sensible,’ he left it to the British Bankers’ Association, which compiles Libor and was reviewing Libor at the time, to decide on whether they should be implemented. The Bank of England said in a statement last week that it didn’t have “any regulatory responsibilities in this area.”

Sleeping on Job?

“It looks like the Bank of England was sleeping on the job,” said Kent Matthews, a finance professor at Cardiff University Business School and former researcher at the central bank. “They may be capable of taking on the regulatory powers, but the question is whether they have the credibility. They weren’t looking at the right thing.”

Andrew Tyrie, chairman of the U.K. parliament’s Treasury committee, told Tucker on July 9 that the bank’s handling of Libor during 2008 “doesn’t look good.” Tucker asked to testify to lawmakers two weeks ago after Barclays released e-mails suggesting he had hinted the lender should lower its Libor submissions.

The controversy is the latest episode to reverberate through London after a year in which the city played host to JPMorgan Chase & Co.’s $4.4 billion trading loss and the alleged $2.3 billion fraud at UBS AG. London was also where American International Group Inc. and Lehman Brothers Holdings Inc. booked transactions that helped lead to their 2008 downfall.

London’s Fate

While research firm Z/Yen Group Ltd. ranks the U.K. capital as the world’s No. 1 financial hub, the Libor case “has an adverse effect on London as a financial centre and decisive steps need to be taken,” said Jon Moulton, founder of venture-capital firm Better Capital LLP.

The government is already moving to prevent a rerun of the regulatory missteps that were laid bare by the financial crisis. In 2010, Chancellor of the Exchequer George Osborne announced that he wanted to abolish the FSA, the financial watchdog set up in 1997 by the previous Labour government, and give most of its powers to the Bank of England.

The plan, which still needs parliamentary approval, would kill the regulatory regime whose light-touch approach has been blamed for failing to prevent the near-collapse of Royal Bank of Scotland Group Plc and Lloyds Banking Group as well as the run on Northern Rock Plc.

Failed Model

Another nail may be hammered into the self-regulation model when Martin Wheatley, head of the FSA’s financial conduct division, publishes a review of Libor next month. His inquiry will look into whether setting the rate should be regulated, whether actual trade data can be used to set the benchmark, and whether officials have enough power to punish financial misconduct, Osborne said this month.

Spurred on by officials such as Geithner, the U.S. is moving faster than the U.K. to build a post-crisis financial framework. President Barack Obama in July 2010 signed the 2,300-page Dodd-Frank law. Regulators are also working to complete rules including a ban on proprietary trading by banks -- the so-called Volcker rule -- and requirements that most over-the-counter derivatives be guaranteed by central clearinghouses and traded on transparent platforms.

Still, the U.S. has little room to lecture the world given its subprime mortgage woes set in train a crisis that tipped the world into recession, said Robert Skidelsky, professor emeritus at Warwick University.

U.S. Bank Collapse

“The Americans are wrong in saying London was in some sense the cause of everything,” said Skidelsky. “The big collapse is in the American banking system.”

Harvard University professor Niall Ferguson also warns the U.K. should also be wary of imposing too many curbs on business. Financial services are the U.K.’s largest export and pay 12 percent of the country’s tax receipts.

“Banks are on the receiving end of a raft of financial regulation that is killing their business model,” Ferguson said at a conference in London on June 27.

The irony is that the Bank of England is being given more powers just as its track record for monitoring the City is being criticized.

“Everyone has said it’s too much for one man or woman,” said Dan Conaghan, author of the book, “The Bank: Inside the Bank of England.” “The job description is a huge amount more than the current governor has to do.”

Play Safe

The Libor turmoil may encourage Osborne to look beyond London’s financial district when King retires next June and appoint someone seen as untainted by the woes to rock the City since 2007, said Conaghan.

Leading candidates include Turner of the FSA, Gus O’Donnell, the former head of the U.K. civil service, Bank of Canada Governor Mark Carney and Osborne adviser James Sassoon.

“They’re going to play it exceptionally safe,” said Conaghan. Tucker, the BOE’s top internal candidate, may now have a “black mark” against his name.

London can still recover from the raft of scandals, and the central bank may be able to defend its actions by pointing to their context. The Bank of England was trying to fight the worst financial crisis since the Depression within a regulatory environment that deprived it of the legal power to force change.

King has recently also shown a greater willingness to take on a more muscular attitude to errant banks. King told Barclays Chairman Marcus Agius on July 2 that then-Chief Executive Officer Robert Diamond had lost the support of regulators. Diamond’s departure was announced the next morning.

“London as a financial center is far bigger than Libor,” said Jim Irvine, head of fixed-income at Henderson Global Investors in London. “We shouldn’t lose sight of the fact that, at the time, the thing we were losing sleep over was the potential implosion of the financial sector. The U.S. got through subprime, and London can get through Libor.”