Libor and the folly of deregulation

August 17, 2012: 5:00 AM ET

The New York Fed dropped the ball during the Libor scandal.  Could it happen again?

By Sheila Bair, contributor

The New York Fed

The New York Fed

FORTUNE – A lot of fingers are pointing in a lot of directions in the Libor price-fixing affair. Tim Geithner is pointing his finger at the Bank of England. Republicans in Congress are pointing their fingers at Geithner. The big banks are pointing their fingers at one another. But one party to this fiasco is not a regulator or a bank but a law: the Commodity Futures Modernization Act (CFMA).

We have a lot of financial regulators with different responsibilities. Like Lou Costello in the old vaudeville baseball skit "Who's on First," it can be hard for us to sort out the identities of the key players. We have "safety and soundness" regulators, who basically focus on an institution's profitability, and we have "market" regulators, who focus on trading and look out for things like manipulation and fraud.

MORE: Four fixes to the Libor scandal

In 2000, during the heyday of deregulation, former Federal Reserve Board chairman Alan Greenspan and Treasury Secretary Bob Rubin told Congress that we didn't need market regulation over the massive and rapidly growing off-exchange derivatives markets because the Federal Reserve Board System provided safety and sound oversight of the major derivatives dealers. Congress agreed and passed the CFMA, which took the nation's derivatives market regulator, the Commodity Futures Trading Commission (CFTC), out of the game. It left the off-exchange derivatives markets unregulated, including the massive $350 trillion Libor-based interest rate swap market. No one had responsibility for monitoring the markets as a whole to make sure pricing was transparent and reflected market realities. To the extent there was oversight, it was done dealer by dealer. The markets themselves were a free-for-all.

The folly of the CFMA can be seen in how the New York Federal Reserve Bank reacted when alerted to potential rate rigging and fraud by Barclays (BCS) employees in 2007 and 2008. (Much of the rate rigging appears to have occurred on Barclays' New York trading desk.) The allegations did not immediately relate to safety and soundness. Indeed, the bank's low-balling of the rate in 2008 arguably helped its financial position by making it look healthier than it was. Instead of launching a thorough investigation, the New York Fed sent a memo to the Bank of England recommending policy reforms. But the Bank of England had no regulatory authority. (In the U.K. at that time all regulatory power rested with the Financial Services Authority.) So it dutifully forwarded the memo to the British Bankers Association, the unregulated trade group that surveyed the banks to set Libor.

MORE: Libor scandal - more evidence for Volcker rule

But it was the CFTC that led the investigation unearthing the Libor scandal. Fortunately for us, there was a smart, alert CFTC enforcement attorney by the name of Vince McGonagle, who in 2008 read an article in the Wall Street Journal about the suspected gaming of Libor. Unlike the New York Fed, he had no insider tips or monitors present at the big derivatives dealers to help him see what was going on. And he had no apparent jurisdiction. But a few Libor-based derivatives were traded on-exchange, and the CFTC prohibited filing false reports on the price of a "commodity." So McGonagle found a loophole and, aided by his colleagues Gretchen Lowe and Anne Termine, launched an investigation, which they doggedly pursued for four years.

The CFTC launched an investigation, and the New York Fed wrote a memo. Why the difference in response? It just reflects the difference in each regulator's DNA. The Dodd-Frank Act restored much of the CFTC's authority over derivatives, though it will take years to rein in these markets where deregulation is well entrenched.

No agency is perfect, and the CFTC has had its own problems. But amid all the finger-pointing, let's give credit where credit is due. The New York Fed was "on first" in this case and bobbled the ball. It took three CFTC enforcement attorneys who had been relegated to the dugout to find a way to enter the game and protect us all.

This story is from the September 3, 2012 issue of Fortune.

  • The death of Bob Diamond's dream for Barclays

    Caught up in the Libor scandal, the star investment banker and American CEO of the British bank was forced to resign. His departure represents the end of an era for big banks.

    FORTUNE -- By the time the call came, Bob Diamond knew his tenure as CEO of Barclays was at an end. It was 9:30 p.m. on Monday, July 2, and Diamond had just gotten home from the office when MORE

    - Jul 30, 2012 5:00 AM ET
  • Barclays and Libor's (lack of) integrity committee

    Trade group put Barclays partially in charge of deciding whether Libor was broken.

    FORTUNE -- A husband and wife team who have launched a website critical of Wall Street practices have uncovered an ironic, and troubling, tidbit about Libor and Barclays.

    Just three months before Barclays admitted that numerous employees at the bank including top executives participated in manipulating Libor, and long after it was widely known to be under investigation, the MORE

    - Jul 25, 2012 2:30 PM ET
    Posted in: ,
  • Barclays the biggest Libor liar? No, that may have been Citi

    A trio of studies indicates that Citigroup understated its borrowing costs more than others.

    Update 7/20, 10:00 A.M.

    FORTUNE -- Earlier this week, Citigroup CEO Vikram Pandit told analysts not to use Barclays' $450 million Libor settlement as a guidepost for what his firm might have to pay. And he could be right. Citigroup (C) might end up paying much more.

    A number of studies have shown that when it comes to lying MORE

    - Jul 19, 2012 12:18 PM ET
  • Barclays scandal: How big will this get?

    By Larry Doyle, contributor

    The earthquake that rocked Wall Street and the global financial markets in 2008 continues to reverberate today. Just ask Bob Diamond, CEO of Barclays (BCS)... or I should say, the former CEO of Barclays.

    Diamond, the once high-flying American banker, was dethroned overnight as the chief executive of the UK-based bank as public pressure and outrage grows over the Libor price-fixing scandal. Do not think for a second MORE

    Jul 3, 2012 11:37 AM ET
    Posted in: ,
  • Judge clears Barclays 'sweetheart deal'

    A federal judge signed off on the Justice Department's settlement of a trade-sanctions case with Barclays.

    The judge, U.S. District Court Judge Emmet Sullivan (right), endorsed the agreement Wednesday, Reuters reported. The move comes a day after Sullivan questioned the toughness of the sanctions and called the pact a "sweetheart deal."

    The decision clears London-based Barclays (BCS) to pay $298 million to settle a Justice Department criminal case alleging that Barclays facilitated business with MORE

    - Aug 18, 2010 1:56 PM ET
    Posted in: , , , ,
  • California dreaming

    The biggest banks can be blamed for many things, but causing a debt crisis in California isn't one of them.

    So concludes a report issued Thursday by the state's treasurer, Bill Lockyer. He said data collected over the past month shows the big derivatives-dealing banks aren't conspiring to send the state's bond yields higher.

    The report says that since 2007, the big derivatives-dealing banks – Bank of America (BAC), Barclays, Citigroup (C), MORE

    - Apr 22, 2010 3:31 PM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.