Continuing LIBOR Scandal Reveals The Farce Of ‘Light-Touch’ Regulation

London became one of the globe’s primary financial hubs partly through its so-called “light touch” regulatory approach — effectively trusting some of the world’s largest and most powerful banking enterprises to manage their own affairs without much government intervention. As a result, the U.K. central bank alternately ignored the burgeoning business of LIBOR-rigging and actively colluded in it at some level, advising banks to raise or lower their estimates in order to create an illusion of stability in the system.

For those not versed in the acronym-littered world of international lending, LIBOR stands for the “London Inter-Bank Offered Rate.” It represents the interest rate banks pay to borrow from each other for a short-term period in ten different currencies and 15 separate durations.

The strange bit comes in during the creation and publication of the rate — a survey of various banks’ estimates of the rate they think they would pay to borrow, for instance, 10 million yen for a one-week period. Those estimates are aggregated, the lowest and highest are knocked out, and the rest are averaged and published each day by the British Bankers’ Association, a private trade organization.

It wouldn’t take a financial mastermind to see how traders could abuse this system. The LIBOR represents a benchmark for derivatives and securities with a nominal value of $350 trillion or more. Skewing the rate by a single point could generate hundreds of thousands of dollars in paper profits, as Bloomberg News showed last week:

There were no rules at RBS and other banks prohibiting derivatives traders, who stood to benefit from where Libor was set, from submitting the rate — a flaw exploited by some traders to boost their bonuses.

The next morning, RBS said it would have to pay 0.97 percent to borrow in yen for three months, up from 0.94 percent the previous day. The Edinburgh-based bank was the only one of 16 surveyed to raise its submission that day, inflating that day’s rate by one-fifth of a basis point, or 0.002 percent. On a $50 billion portfolio of interest-rate swaps, RBS could have gained as much as $250,000.

Of course, it’s not as if the banks are getting away scot-free — Barclays Bank coughed up more than $400 million in fines last summer for its part in the scam, Swiss giant UBS paid over $1.5 billion to regulators on both sides of the Atlantic, and RBS will probably pay close to $800 million in settlements, Reuters reports.

For politicians and voters on both sides of the Atlantic, the lesson should be clear — give banks the operating room to manage themselves, and they’ll use that license to steal as much money as they can. This really shouldn’t be a surprise to anyone who’s been paying attention to the pattern of fraud, deceit and collusion that characterized the explosion of the finance sector in the last two decades.

It will be interesting to see if, as the Guardian reports, Chancellor of the Exchequer George Osborne follows through on his threat to break up banks that continue to violate new regulations. The other question is how much, if any, traction U.S. regulators can find on this fiendishly complicated, globe-spanning scandal.

Most Americans have little knowledge of LIBOR, though it plays an essential role in determining everything from the stability of their municipalities’ investments to the interest investors receive from money market funds. According to The Wall Street Journal, the Department of Justice does appear to be seeking criminal charges against responsible parties at RBS, a hopeful sign. The real test will come if and when the details of further crimes at US-based banks come to light – will regulators take the same aggressive approach? Or will they fall prey to the light touch mistake once again?

Our guest blogger is Daniel Pereira, Managing Editor at Brafton Inc.