As many readers probably know, there has been a huge scandal recently about the setting of the London InterBank Offer Rate (LIBOR). This is the rate used around the world on literally trillions of dollars in loans, including many mortgages.
Marc Joffe has a good blog post on the facts of the scandal. What is the scandal? Here's Joffe:
In the case of LIBOR - as with bank loan prices and CDS spreads - the mechanism involves dealers reporting their bids and offers to a data aggregator, like Thomson Reuters or MarkIt. The aggregator then averages the reported quotes, often dropping the highest and lowest marks from the composite. As we've now seen, these dealer quotes are subject to manipulation. In less liquid markets, they may not be updated regularly since the dealer does not see new bids or offers. In either case, the composite marks reported by the aggregator do not reflect actual value.
In other words, various companies lied in reporting rates. Joffe also notes:
This instance of financial industry malfeasance appears to lack the compelling narrative needed to upset the general public. For those advocating on behalf of the "little guy", this scandal may lack appeal, since most of the LIBOR manipulation appears to have been downward -thereby lowering mortgage rates paid by ordinary borrowers. Financial industry critics seem less concerned by the fact that many "little guys" who directly or indirectly invest in LIBOR-based vehicles were cheated out of some income. Journalists and bloggers have thus focused their ire on the rich and powerful individuals who have been caught cooking the books. This is unfortunate, because chopping off a few heads is not the real solution. As we will see in the coming days and weeks, misreporting of bank borrowing rates was pervasive. It is simply too tempting for most of us mortals in the financial industry to resist.
Where I part company with Joffe is on his solution. He writes:
A better alternative would be to require all bank transactions to be reported and made publicly available. Reporting should be real time, easily accessible on the internet and as detailed as possible. Specifically, consumers of the data should be able to identify inter-dealer trades that may be executed for the purpose of manipulating mark-to-market prices.
Put aside the serious objection that this is would be a large government attack on people's freedom. Even if that weren't the case, such a measure can have some nasty unintended consequences. One obvious one is that it would facilitate collusion and cartels. One of the biggest barriers to collusion is that the members of the cartel can't know if their fellow members are cheating on collusive agreements. The cartel members can agree to share information about prices, but just as they have an incentive to cheat by cutting prices a little, so also they have an incentive to cheat by misreporting prices. And it is that incentive to cheat that protects us consumers.
But now, as Joffe would, have the government enforce accurate reporting, and back it up with fines, and now the information that the companies report will be more accurate. Result: collusive agreements are easier to enforce.
Requiring audits of participants' sales, creating financial incentives for customers to report price discounts offered to them, and setting up systems to monitor emerging threats of entry are among the tools that can help cartels detect cheating.
So what's my solution? The publicity that has occurred about LIBOR is part of it. To the extent that the word gets out that LIBOR is not an honest or accurate estimate of average interest rates, people will demand honesty or find alternative measures that are more accurate.
When I advocate free markets, I don't do so with the idea that no one in markets will make mistakes or that no one will cheat. Many people will make mistakes and many people will cheat, especially with new financial vehicles. But what the market offers as a solution, which government regulation doesn't do as well at, is that when people find out about it, they can act on the information. Here's what economist Ben Klein wrote about how brand names protect consumers:
Consider, for example, the case of defective Firestone tires on Ford Explorer sport-utility vehicles in 2000. Because consumers cannot ascertain the quality of tires by direct examination, they rely largely on the tire supplier's brand name, which was badly damaged in this case. One day after Bridgestone (Firestone's Japan-based parent company) announced the recall of the defective tires, Bridgestone's stock price dropped nearly 20 percent; it continued to fall over the next three weeks as additional information about the problem was disclosed. Overall, this amounted to a decline of nearly 40 percent in Bridgestone's stock-market value relative to the Nikkei general market index. Ford's stock price did not drop initially, but eventually it fell about 18 percent relative to the S&P 500 index over the same period as information was revealed that Ford was aware of the possibility of tire failure more than a year before the tire recall. These stock-market declines amounted to losses of about $7 billion in Bridgestone's market value and nearly $10 billion in Ford Motor Company's market value--market measures of each company's future lost profit caused by these events. These costs were substantially greater than the direct costs associated with the recall and liability litigation, estimated by Bridgestone at $754 million and by Ford at $590 million. Although these direct costs clearly were substantial, they were dwarfed by the brand-name market costs borne by Bridgestone and Ford, which were between some nine and seventeen times as large.