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Emerging markets

Dream on?

The emerging economies cannot blame all their woes on the rest of the world

Jul 21st 2012
HONG KONG




FIFTEEN years ago this month, Thailand at last allowed its currency, the baht, to fall against the dollar, abandoning a long, losing battle with market forces. “I haven’t slept for two months,” said the governor of the central bank on the day of the devaluation. “I think that tonight I’ll be able to sleep at last.”
What followed was a five-year nightmare for emerging markets, as the financial crisis spread to Thailand’s neighbours, then to Russia and Brazil, before eventually claiming Argentina and Uruguay in July 2002.
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After the tossing and turning of 1997-2002, the next decade went like a dream. In 2003 China resumed double-digit growth; India’s economy expanded by 8%, a feat it would surpass in four of the next six years; Brazil’s new president, Luiz Inácio Lula da Silva, appeased the IMF and the bond markets by cutting public debt and achieving the first of five annual current-account surpluses. Goldman Sachs released the first of its 2050 projections (“Dreaming with the BRICs”, its catchy acronym for Brazil, Russia, India and China), suggesting that the big emerging economies would eventually inherit the Earth.

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The crisis-hit countries emerged from devaluation, default and distress with low expectations, cheap and flexible currencies, scope to borrow and room to grow. Global capital markets welcomed them back, buying their equities and their bonds, even when denominated in their own currencies. The popular emerging-markets stockmarket index compiled by MSCI rose by over 350% from the end of 2002 to its peak in October 2007.






Rather than spend these capital inflows, emerging economies recycled them. They amassed foreign-exchange reserves as a guarantee against ever again succumbing to a currency crisis or the ministrations of the IMF. Some have even begun to help fund the fight against crises elsewhere. On July 10th Indonesia’s central bank confirmed it would buy $1 billion of the IMF’s notes, a poignant reversal of roles.






But after a dream decade, something is amiss. China is now struggling to grow as fast as 8% (its GDP expanded by 7.6% in the year to the second quarter). India, a country that once aspired to double-digit growth, can now only dream of ridding itself of double-digit inflation. None of the biggest emerging economies stands on the edge of a dramatic financial precipice, like their counterparts in the euro area, or a fiscal cliff, like America’s. But their economic prospects have nonetheless started to head downhill.
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The MSCI emerging-market index is flat for the year and still 30% below its 2007 peak. Only 15 months ago, the IMF’s forecasters expected Brazil’s economy to grow by over 4% this year. This week their 2012 forecast was just 2.5% (see chart 1). Over the same period, South Africa’s 2012 growth forecast was cut from 3.8% to 2.6%.






Some of this slowdown can be blamed on events elsewhere. Europe’s pain, for example, has spread far beyond its immediate neighbours. The European Union remains the biggest foreign market for many emerging economies, buying about 19% of China’s exports and 22% of South Africa’s. Euro-area banks have also begun to sell assets and withdraw lending. They account for about 45% of credit to emerging Europe and a substantial share of trade credit in Asia.






Some of the slowdown was also orchestrated by governments nervous about price pressures or property bubbles. Poland’s central bank raised rates as recently as May to quell inflation, which persists above its 2.5% target. China’s premier, Wen Jiabao, fell into a game of chicken with the country’s 50,000 property developers, waiting for them to cut prices, even as they waited for him to lift restrictions on multiple home purchases. As growth slows, policymakers will ease in response.




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But there is more to this story. The slowdown is not simply a demand-side phenomenon, the result of weak exports and past tightening dragging growth below its long-run potential. The underlying rate of sustainable growth may also be less impressive than previously thought. As the IMF pointed out this week, the last decade or so may havegenerated overly optimistic expectations about potential growth”.




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High commodity prices boosted some emerging economies, such as Brazil, Russia and South Africa. They also flattered emerging-market share prices. As Bank of America Merrill Lynch observes, natural-resource industries account for more than a third of the market capitalisation of the BRICs and over a quarter of the market cap of MSCI’s benchmark index.
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The dream decade was also sweetened by rapid credit growth, according to the fund. The ratio of bank credit to GDP has risen steeply in many emerging economies (see chart 2) over the past ten years. From trough to peak, it rose by over 20 percentage points in Brazil, China, the Czech Republic, Hungary, Malaysia, Poland, South Korea, Taiwan and Turkey. It rose almost as far in India and Russia.




In some emerging economies, the upswing began late in the decade. In China, the credit ratio has risen by over 27 points since 2008 alone. In others, it has already ended: in South Africa, Hungary and South Korea, the credit ratio has fallen substantially since the financial crisis.




A rising credit ratio may represent healthyfinancial deepening” as the banking system does a better job of capturing household saving and reallocating it to its best use. But it may also reflect a potentially destabilising financial cycle”, an upswing in credit and other financial variables, which overlays and often outlasts the swings in GDP and inflation that mark conventional business cycles.




The upturn in the financial cycle may flatter growth, as easy credit encourages spending and speculation, boosting the value of collateral and thus easing credit further. This may have lulled emerging economies into thinking they could grow faster than they really can, just as permissive finance helped persuade the rich world that its growth was more stable than was actually the case.




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Ninety-nine cred balloons
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When credit booms show up in inflation, central banks are typically quick to react. But consumer prices often remain tame, because rising exchange rates and imports fill the gap between expanding domestic demand and supply. That allows the booms to grow dangerously large. Selim Elekdag and Yiqun Wu of the IMF have identified 99credit balloons”, episodes of fast credit growth over the past 50 years in rich and emerging economies alike. Of these balloons, 44 popped badly (resulting in a banking crisis, currency crisis or both) and another 13 very badly, with a 9% contraction of GDP on average.




In Asia’s emerging economies, credit ratios have risen further and faster than they did before the Thai crisis, says Frederic Neumann of HSBC. Even so, the region’s central bankers need not lose too much sleep. Now, unlike then, bank loans have not outstripped deposits. And in most countries, domestic investment has not outstripped domestic saving.



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If foreign capital were to withdraw abruptly as it did 15 years ago, the effects would not be as ruinous. Most foreign-capital inflows come in the form not of debt but equity, which shrinks to fit an economy’s ability to pay. The debt of Asian economies is also now partly in their own currency, which would fall in a crisis, taking some of the strain. If foreign capital retreats, Asia’s surplus countries should have enough resources to replace it, although the switch may not be entirely smooth.





The picture is different in Europe. In Poland, for example, credit to the private sector grew by an extraordinary 36.6% in 2008, contributing to a current-account deficit of almost 9% of GDP. The crisis interrupted these excesses but did not reverse them: the country’s external deficit remains over 5% of GDP. In recent months, the FDI and portfolio capital Poland requires to fill this gap has flowed in the wrong direction. That leaves the country uncomfortablysusceptible” to the euro crisis, says Raffaella Tenconi of Bank of America Merrill Lynch, if it prompts a further withdrawal of cross-border lending.




If the credit cycle has got out of hand, who is to blame? Policymakers in emerging economies sometimes present themselves as powerless victims of vague global forces, such as the “tide of liquiditysupposedly sweeping across the globe, thanks to near-zero interest rates in America, Japan and the euro area. But research by Mr Elekdag and Fei Han, also of the IMF, suggests that such external factors explain only a small portion (16%) of the variation in credit growth in emerging Asia. By imposing curbs on domestic credit and allowing greater flexibility in their currencies, economies can regain greater control.
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As the financial cycle ebbs and emerging economies slow, must they forget the “dream” of an “emerging century”, as Jonathan Anderson, formerly of UBS, has put it? Not yet. By 2010, the combined dollar GDP of the BRICs was already about 75% bigger than Goldman Sachs foresaw when it made its original projections seven years earlier. There is therefore a substantial margin for error.




The big emerging economies may never again grow as fast as they did after 2003. But the BRICs scenarios did not assume they all would. In its latest projections, released last year, Goldman Sachs envisioned average growth for the rest of this decade of 5.2% in Brazil, 5.4% in Russia, 6.3% in India and 6.9% in China. It now looks as if Brazil and Russia may fall short of this projection. But China and India can still dream of fulfilling it.



July 17, 2012 8:08 pm

Breaking up banks will win investor approval

Ingram Pinn illustration





The debate on bank reform has reached a curious moment. In one half of the conversation, regulators are discussing how to make banks safer for society. In the other half, equity investors are discussing how to make banks safer for their portfolios. If you put the two halves of the debate together, you soon realise that the regulatory conversation is topsy turvyat least in one crucial respect.





The regulatory discussion generally presumes that “reasonablereform must leave banks intact. Breaking up too-big-to-fail lenders would do violence to the private sector; by contrast, demanding that banks raise extra capital is a market-friendly way to avoid taxpayer bailouts. But the actual conversation in the markets inverts this presumption. Among equity investors, breaking up banking behemoths is increasingly regarded as desirable; by contrast, boosting banks’ capital is anathema. If a “reasonablereform is one that goes with the grain of preferences in the market, busting up the banks may actually be more reasonable than forcing them to hold capital they absolutely do not want.





It is easy to see why investors are eager to dismember the big banks. The promises of synergies trotted out by empire-building bosses in the 1990s have proved largely empty; clients don’t necessarily want to buy underwriting or wealth management services from the same supermarket that provides their ordinary loans. Meanwhile, the risks in empire building are evident. If even the respected JPMorgan Chase can lose billions on a sloppy trade in one wayward outpost, then imperial overstretch is everywhere. “Banks are increasingly regarded as unanalysable and uninvestable,” says Mike Mayo, an analyst for CLSA on Wall Street.




Investors’ scepticism shows up in share prices. The stock market capitalisations of Citigroup and Bank of America languish at half and three fifths of tangible book value, respectivelyliquidating Citi could hand shareholders a gain of 100 per cent. Indeed, because banks’ assets include infrastructure that could be sold for much more than book value, the bonanza might be even bigger. JPMorgan’s market capitalisation is roughly equal to its book value, but analysts reckon that the bank might be worth about a third more dismembered than intact.





If the attraction of bank break-ups is obvious, so is the hostility to regulatory efforts to require banks to raise more capital. Traditionally, banks have preferred to issue debt rather than equity because the government has perversely subsidised leverage. The double taxation of corporate profits has rendered debt tax-efficient; deposit guarantees have subsidised borrowing from retail customers; central bank liquidity has made short-term wholesale borrowing artificially cheap. However, these long-standing incentives for leverage have now been fortified by two new ones.





The first comes from the realisation of banks’ too-big-to-fail status. Since 2008, it has been clear that banks’ unsecured bondholders stand a good chance of being bailed out in a crisis. This has created a subsidy for bond issuance, distinct from the old subsidies for collecting deposits and issuing short-term paper.




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Whereas in the past it was only quasi-government lenders such as Fannie Mae that issued bonds cheaply, thanks to an implicit government backstop, now all the big banks enjoy this privilege.




While bond issuance has acquired a subsidy, equity issuance has grown more expensive. To limit moral hazard, crisis bailouts were crafted so as to make shareholders suffer; thus AIG’s shareholders were taken to the cleaners even as the banks that had incautiously bought its derivatives got off scot-free. As a result, equity investors today do not expect the government to rescue them. In contrast to bondholders, shareholders see banking behemoths as scarily complex, not comfortingly protected.





This too-big-to-fail effect shows up clearly in the prices of equity and debt. A non-financial corporation choosing between equity issuance and bond issuance could reasonably go either way.



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For example, Coca-Cola’s shares sell for 17 times next year’s expected earnings, meaning that equity investors demand a return of 5.8 per cent in order to buy the shares. Since Coke can issue long-term bonds at just over 4 per cent, equity is only 1.6 percentage points more costly. By contrast, Bank of America, JPMorgan, and Citigroup face a far larger wedge: 7.5 percentage points, 10.4 percentage points and 11.8 percentage points, respectively. Banks frequently moan that equity is expensive. Thanks to regulators’ selective concern with moral hazard, they have a point.




Finally, as Stanford’s Anat Admati has noted, bank shareholders do not want to cut leverage because of a classic debt overhang effect. Normally, the owners of a healthy company may accept the expense of issuing equity rather than debt. They do so to reduce the risk of bankruptcy, since equity investors, unlike bond investors, agree in advance to forgo payouts in hard times. But when a company is already unhealthily indebted, creditors resemble owners; the odds of bankruptcy are rising, so bondholders also face the danger that their cash receipts may stop.



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In this circumstance of debt overhang, the effect of deleveraging is to cut the risk borne by bondholders – or by the government that backstops them. Equity holders get stuck with higher financing costs and no compensating fall in risk.
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None of this means that bank regulators should stop insisting on more capital. On the contrary, bank investors’ losses from deleveraging will be society’s gain. But the capital adequacy police should be aware that they are pushing against powerful incentives to evade their edicts. If regulators want a “reasonablepolicy that will be accepted by the equity market, they should break up the giant banks.




The writer, an FT contributing editor, is a senior fellow at the Council on Foreign Relations



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Copyright The Financial Times Limited 2012.


The LIBOR Mess: How Did It Happen -- and What Lies Ahead?

Published : July 18, 2012

in Knowledge@Wharton

The LIBOR Mess: How Did It Happen -- and What Lies Ahead?




When regulators in the United Kingdom and United States announced a settlement with Barclays bank over its manipulation of LIBOR, the benchmark interest rate used around the world, there were plenty of reasons for jaws to drop. First and foremost was the whopping fine of $450 million, reflecting the seriousness of the case, along with analysts' predictions that LIBOR rates could influence interest rates on between $350 trillion and $800 trillion in loans and investments. That's not a mistake -- trillion, with a "T".







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Now it looks as if many major banks may have been involved, with about a dozen of the biggest names in the world under investigation for rate fixing intended either to pad profits or to make themselves look financially healthier than they were. Regulators may have glanced the other way. Civil suits from investors, pension funds, government entities and others dependent on LIBOR may eventually cost big banks billions in damages.





"What interests me the most is that it shows once again how unexpected failure in the system can pop out of almost anywhere and become so major," says Wharton finance professor Itay Goldstein.
How did this mess happen, who was hurt and what's to be done about it?






'Shocked' at the News



Among the surprising aspects of the story: Many thought this issue had been addressed years ago. The first public hints of trouble came in 2007 and 2008, after which the British Bankers Association (BBA), which calculates LIBOR rates every day based on submissions from participating banks, took steps to stop the fudging of these numbers. It turned out those measures were not at all ironclad.





"It's remarkable that people are surprised LIBOR could be manipulated," notes Wharton finance professor Richard J. Herring, comparing the recent reaction to the police official who was "shocked!" to learn about gambling at Rick's place in the film Casablanca. "It's been more or less an open suspicion since at least 2007," Herring says, adding that "the rate after the crisis was determined by the British Bankers Association according to a slightly modified approach which was intended to be more transparent, more broadly representative and harder to manipulate."




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Twenty of the world's largest banks submit their interest rate data to the BBA at 11 a.m. each day. While the shorthand term LIBOR, for London Interbank Offered Rate, makes it sound like one rate, there actually are calculations in 10 currencies for 15 loan terms ranging from overnight to 12 months.




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The procedure for setting each benchmark is the same. "The BBA then throws out the top 25% of quotes and the bottom 25%, and takes the average of the remainder," Herring says. "On the surface, this makes it seem highly unlikely that any one bank could manipulate the rate, but on closer inspection, it is possible."




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If a bank's true rate was actually in the top quarter of all those submitted, but the bank reported a figure in the bottom quarter, another bank's rate might be lifted from the bottom into one of the middle quarters, according to Herring. Thus, a low rate that should have been thrown out would end up being used in the calculation. "The impact on the quoted LIBOR could be rather substantial." If numerous banks understate their rates, the average is sure to be lower than it should be.





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"The fundamental problem," Herring adds, "is that LIBOR is a hypothetical rate -- the rate at which each of the 20 banks on the panel believe they could borrow funds at 11:00 a.m. It is not a transaction rate, and although it is possible to see what each of the banks has quoted, it is not possible to verify the quoted LIBOR rate contributed by each bank against an actual transaction."


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At its heart, it is an honor system.




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Why did the BBA changes not discourage underreporting? Because the banks felt they were in a corner, says Wharton finance professor Krista Schwarz. "Especially in 2008, the biggest problem was that all the banks wanted to claim they were able to borrow more cheaply than was in fact the case, so as not to heighten concerns about their creditworthiness."





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But if LIBOR's rates can be so easily manipulated, why use them? After all, the financial world offers a cornucopia of rates that are set by the marketplace and are therefore virtually impossible to rig. Rates on government and corporate bonds, for example, are governed by supply and demand and can be tracked through trading data, while LIBOR rates cannot.





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"It's surprising that LIBOR has become so important, because of the imprecision and the lack of verification" by regulators of the rates that banks report, states Wharton finance professor Jeremy Siegel. "To some degree, it's just convention," adds Mark Zandi, chief economist of Moody's Analytics, describing LIBOR as "an historical artifact." Banks continue to use it because they have done so in the past.




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In theory, LIBOR reflects what banks expect to pay to borrow every day in deals with one another. "They look at the rate they expect to borrow at rather than the actual rates" they do borrow at, according to Goldstein. This system is intended to reveal the banks' real cost of money, incorporating all the market's up-to-the-minute assessments of the risk of lending to the participating banks. In contrast, a U.S. Treasury bond rate, while set more transparently, does not include default risk. Investors believe the U.S. government will pay its debts, while they cannot be so sure a bank will, so the two rates reflect a different set of concerns.






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There have not been many problems with LIBOR prior to the financial crisis. Therefore, there was little reason to question its use, which has broadened because of London's dominance in the world financial markets, a certain pack mentality and tradition: Since many institutions use it, many others follow suit.





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"The LIBOR rate affects a large number of end borrowers whose loan terms are variable, which includes both corporations and municipalities with floating rate debt and, especially, households with adjustable rate mortgages, student loans and some credit cards," says Wharton finance professor Nikolai Roussanov. In fact, about half of adjustable-rate mortgages in the U.S. track LIBOR, he adds.








In a typical case, the mortgage is recalculated every 12 months by adding a fixed number of percentage points to the LIBOR rate that day. The higher the rate, the larger the borrower's monthly payment, and vice versa.








.While an artificially low rate benefits borrowers by reducing monthly payments, that boon was probably small, he notes, since instances of understatements apparently did not last very long.




Minuscule Change, Major Gain





More important than consumer loans is the use of LIBOR for fixed-income derivative contracts, Roussanov says, adding that the most common are interest rate swaps, in which the party on one side makes regular fixed payments to the other party, while the second party makes a floating payment to the first based on LIBOR. Swaps have various uses, such as managing the investor's exposure to changes in interest rates. With swaps, each side therefore makes a bet based on the relationship of fixed and floating rates. If LIBOR rates are not what they ought to be, some traders will make more than they should, others less. At the end of 2011, the value of outstanding swaps contracts was about $18 trillion, according to Roussanov.





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Government investigators are also looking into evidence that some banks tinkered with LIBOR to boost gains on specific contracts, as a minuscule change in LIBOR could be worth millions of dollars on a large position.






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Most of the time, LIBOR rates move in tandem with other rates that are easier to verify, indicating LIBOR does indeed accurately reflect the rise and fall of prevailing rates. But occasionally these relationships change, causing raised eyebrows. Beginning in 2007, the gap between LIBOR rates and market-set rates like the Fed Funds rate began to widen, an alarming development that worsened in 2008, Siegel says. "I was appalled by how much that rate went up, hurting borrowers."





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The LIBOR rate spiked after the Lehman Brothers bankruptcy in 2007, reflecting worries about the banks' financial health. They were wary about lending to one another, and the volume of lending plummeted, Siegel notes. Then the process reversed, and LIBOR fell to a full percentage point below that on a comparable U.S. Treasury bill, reversing the usual relationship.





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"Analysts found this highly suspicious," Herring recalls. While the comparatively low LIBOR rate indicated lenders thought the banks were relatively safe bets, other rates governed by the marketplace, such as the Overnight Index Swap Rate, showed just the opposite. Amid the worst financial crisis since the Depression, with the credit markets all but frozen, it was impossible to believe the banks were lending to one another at such reasonable rates. "This may be another good example of Goodhart's Law: Whenever you focus on a rate for policy purposes, you will set up incentives to manipulate the rate," Herring notes.




.After Lehman, investigators began digging into the LIBOR-setting system. "The suspicion was that several banks that were having trouble funding themselves in the market tried to disguise their distress by quoting much lower rates than they would be obliged to pay -- if they could borrow at all," Herring says.





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Aside from this image polishing, investigators began to suspect other motives, he adds. "While [looking into] allegations that banks were understating their rates, officials uncovered emails suggesting that at least one bank attempted to manipulate LIBOR to increase its profits at rollover dates, in settlement of Eurodollar futures transactions and swaps based on LIBOR." Goldstein points out that "banks have all sorts of contracts that depend on LIBOR, and decreasing the rate can increase their profit." Manipulating the rate to boost earnings is fraud, he says.





Looking the Other Way




The recent spate of news suggests that a number of the world's largest banks were doctoring the LIBOR rates, and that regulators had some knowledge of what was going on but did little, perhaps because they, too, wanted to shore up confidence in the banks amid the financial crisis. "There's a kind of weird irony in all this," says Zandi, noting that it truly was important to boost confidence in the banks during the crisis. "This is really scandalous, but, on the other hand, [the rate trimming] may have helped forestall a much worse crisis."






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"I can see no reason [why] they would have condoned manipulation of the rate for the profit of particular banks in particular transactions," Herring says of regulators. "Their concern about overall confidence in the banking system in the depth of the crisis, however, makes it plausible that regulators would have been pleased to see LIBOR decline and perhaps [were] not tempted to ask very probing questions."






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Schwarz adds that regulators had a lot of other things going on at the time and "probably did not think that this was the most pressing problem. Also, regulators had no easy tools to address this. It is, in particular, hard to see what U.S. regulators could have done in real time to deal with a rate produced in London."





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This is not, however, a case of no harm, no foul. Borrowers such as homeowners would have benefitted if an artificially low LIBOR kept their payments below what they should have been. But that would have occurred at the expense of lenders and their shareholders. "If they charge the wrong rate, it's just not fair to one party or the other," says Siegel.





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Because changes in LIBOR also govern returns on various types of investments, it is clear that pension funds, mutual funds, municipalities and other investors are likely to have been hurt as well. A string of lawsuits has been filed by investors and, though the cases may take years to resolve, some analysts predict the major banks will pay out billions in damages, which will not please their shareholders.





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Another casualty, says Herring, is public confidence in large banks. The industry has been trying to stave off heavier regulation following the financial crisis, and public distrust could make that harder. In addition to the LIBOR scandal, the public has been bombarded with news about the multi-billion dollar trading losses at JPMorgan Chase, as well as allegations that the bank's financial advisors improperly steered investors to house-brand mutual funds that performed worse than competitors' offerings. To bank critics, the LIBOR case is just more evidence the banks cannot be trusted and need tighter oversight and restriction.





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LIBOR could even become a factor in the U.S. presidential campaign, as Republican Mitt Romney wants to repeal the Dodd-Frank reform laws passed, with President Obama's backing, after the crisis.
In fact, there is little to nothing in Dodd-Frank that applies to the LIBOR case, says Schwarz, noting that she expects the LIBOR scandal to strengthen the hand of those seeking tougher regulations.



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"It seems to be having a stronger effect along those lines in the U.K. than in the U.S.," she says. "Since LIBOR is produced in London, it is U.K. regulation that matters the most. For now, U.K. regulators have no direct supervisory authority over LIBOR, but I expect that will change."






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Regulating financial markets is often a tightrope walk, adds Goldstein. "When bankers don't face constraints or regulation, then they do whatever serves their interests. If you want them not to do [something] and not to put the system at risk, then you need to put in more regulations and constraints.... But you don't want to go to the other extreme, where government controls everything."





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Choosing Another Benchmark




Going forward, a key question is whether LIBOR should be replaced with another benchmark less susceptible to manipulation. But LIBOR is so embedded in the world's financial system it would be impossible to eliminate its use overnight. In addition, says Herring, LIBOR is unique in providing a very wide variety of terms, from overnight to one year.





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Herring notes that rate setters could ask banks what rates they would be willing to lend at, rather than what they think they could borrow at. "This may reduce the incentives for understating rates." Another alternative, he adds, would be to use actual transaction rates, such as those on the Overnight Index Swap Rate, the US Treasury bill rate, or something else. These would be harder to manipulate, but currently do not come in as wide a variety as do LIBOR rates.





"Given this [scandal], I think we should be rethinking how all these debt instruments are priced," says Zandi. "Why not price off something like the Federal Funds rate, or the interest rate on reserves, or something we know for sure is accurate?"






Schwarz, who once worked on the Federal Reserve's money market desk, believes there are options if players conclude LIBOR is too tainted to redeem. "The obvious thing is to use a rate that is based on actual transactions," she says. "That's already done for the effective Federal Funds rate published by the Federal Reserve Bank of New York. It's even done for eurodollar transactions based in New York, called NYFR. I can't see any reason why this could not be set up fairly quickly."