Thursday, March 14, 2013

Who Regulates the Markets? Price Fixing in Interest Rates, and now also Gold?

Wall Street Journal is reporting that The Commodity Futures Trading Commission (CFTC) is investigating whether five banks have been manipulating the price setting in the London Gold market. If it does find evidence of market manipulation, the CFTC can take a big bite out of the banks. It was the CFTC that forced banks Barclays, Royal Bank of Scotland, and UBS to settle for fines that totaled more than $1.2 billion after finding evidence of manipulation of the Libor (London interbank offered rate, an interest rate), with additional payouts to other regulating agencies. It is not yet clear that there was manipulation of the gold price too, but having another such case has brought the issue of market regulation back into the news.

When there is illegal activity in a market, clearly someone profits. That is the whole point of breaking the law. But who are the losers? In the Libor manipulation, the answer is complicated because it was used as a benchmark interest rate in many kinds of contracts. For example, a high Libor rate over a period of time will make ordinary consumers lose money because house mortgages are indexed to the Libor rate, but deposits are generally not. And in any case, most people owe more money on their house than they deposit in the bank, so any increase in the mortgage interest rate is bad for them.

When interest manipulation is involved, it is easy to think about consequences like this, and the Libor manipulations have been described as the banks defrauding consumers. Actually it is more complicated. The manipulation was not always done to increase the Libor; sometimes it was to decrease it. And, the Libor is also what it says: it does influence the interbank lending rate (at least for the banks who do not know that it has been manipulated), meaning that there are banks both as winners and losers when transactions happen at a Libor rate set to a different level than a free-market rate would have been. The Libor scandal was not about "the banks" gaining while everyone else lost; it was a small set of banks gaining advantages over all other banks.

If a few banks had tried to grab money from the customers through collusion, one might have expected a free market to break this collusion through other banks offering better rates. That is the argument for self-regulation: competition will take care of things. The reason the regulators intervened in the Libor case is that competition could not take care of things. The colluding banks were the only ones with a chance to influence the interest rate because only they had a seat at the rent calls.

All of this should not have been a surprise, because self-regulation fails whenever there is a small and powerful clique with strong motives to cheat. Indeed, it should be especially well known in banking. One reminder of this is the recent article on the New York Clearing House Association (NYCHA) by Lori Quingyuan Yue, Jiao Luo, and Paul Ingram in Administrative Science Quarterly. A clearing house is a mechanism for executing money transfers, but it also took on roles of market self-regulation and prevention of failures during bank panics. This was very useful in the period before the government started supporting banks during panics, but there was a problem: The NYCHA did not play fair. Just as in the market manipulation cases, a few elite banks got disproportional advantages. Indeed, not all banks were even allowed into the NYCHA, and those left outside of its umbrella had greater risk of failure. This is natural; when a powerful group uses its control to the disadvantage of others, the others suffer. But bank panics get worse when some banks fail, so Yue and coauthors were also able to show that the NYCHA hurt its own members as well. So, self-regulation has two problems. Elites may take over, to the disadvantage of others; and the same elites may not be astute enough to even protect themselves. (On the latter point, an article by Don Palmer, Jo-Ellen Pozner, and me has looked at the processes leading to misconduct -- they are not always rational.)

Moving to our own recent case, the fines in the Libor case clearly hurt the banks that were caught manipulating rates. The ease by which the CFTC could show that market manipulation had occurred through email records suggests that these banks were very optimistic about their chances of getting away with it. After seeing that they even had difficulty taking care of their own interests, maybe we should be careful about trusting these same banks to be good guardians of the entire financial system.

Burne, Katy, Matt Day, and Tatyana Shumsky. 2013. U.S. Probes Gold Pricing. Wall Street Journal, March 13 2013.