July 16th, 2012
By The Left Banker
For the past 30 years, the global economy has built up increasingly vast amounts of public, private and household debt. This was to compensate for the fall in real wages and to avoid a repeat of the crisis of over-production of goods and services seen from mid-1970s to early 1980s; that is, to avert the classic cycle of boom and bust. To insure these mountains of debt, unregulated derivatives markets were allowed to exponentially grow from late 1990s to the credit crunch in 2007.
A notional $600 trillion of these derivatives are in existence, of which a notional $500 trillion is linked to insuring interest-rate risk through Libor swaps. The total value of this unregulated market is around $30 trillion.
A process known as the ‘financialisation’ of the global economy has accompanied the headlong growth in derivatives, which has inextricably tied the fortunes of the people in mature economies to the fortunes of complex hybrid financial organisations, once known as banks.
These ‘banks’ are able to make huge profits and losses trading these debt and derivative instruments by following the ‘big cake’ approach. In this case, the cake is worth 100s of trillions of dollars — and its main ingredient is the money in our pension and insurance funds. If you cut it into lots of small pieces and buy and sell them, merely brushing up the crumbs makes you very rich.
Profits can be made larger or losses smaller by manipulating these largely unregulated and non-transparent debt and derivative securities. That is what the fixing of Libor was for the most part about. But Libor fixing is just the tip of the iceberg. The London Inter-bank Offered Rate is just one of a whole host of interest rates and prices that are manipulated by banks on a daily basis.
The other part of the fixing relates to New Labour’s desire to disguise the true depth of a financial crisis that was very much of its own making. While it suited Barclays to high-ball Libor — most of their clients were paying the bank Libor and receiving a fixed rate from Barclays in their swap deals — it did not suit the government of prime minister Gordon Brown. As the crisis intensified in 2007-08, the higher the Libor, the greater the risk of having to nationalise the banks.
What are the consequences of the Libor scandal? The move to a regulated central market for derivatives trading, demanded by the G8 in Pittsburgh in September 2009, will almost certainly accelerate. The banks have been dragging their feet on this but now don’t have a leg to stand on.
London’s role as a financial centre will further diminish. It is seen as arcane club, many of whose methods would pass for fraud in the USA. Brussels, Frankfurt and New York will benefit by having transparent markets where prices are based real transactions rather than fakery and what suits the banks.
The banks themselves will be financially penalised. Estimated costs of $22bn (£14.3bn) in regulatory fines, legal bills and civil damages have been doing the rounds. But if there is a wider investigation into the swap markets, the costs are likely to be far higher. If swaps are found to have been sold too expensively to pension funds on both sides of the Atlantic, litigation costs alone would run into the hundreds of billions of dollars. Many banks may, once again, have to be bailed out by taxpayers — the very people they ripped off in the first place.
The Left Banker is a former head of equity derivatives research and strategy at Goldman Sachs