Manipulating the Libor: how low can banking go?

In the last financial crisis the headlines were full of new derivative instruments called Credit Default Swaps (CDS), Collateralised Debt Obligations (CDO) or sub-prime portfolios. These instruments were built on a large leverage, and they caused the collapse of certain US financial institutions in 2009. Since then we have seen that when banks go bankrupt, it hits the economy hard, from depositors to borrowers. Governments, using taxpayer money, then needed to step in by injecting liquidity and or equity in order to keep those ailing banks going. Thereafter, regulators in the US and Europe have tried to find ways to control banks’ stock-market trading and derivative activities. Authorities use the phrase “Too big to fail” to describe giant financial institutions whose failure would threaten the very existence of the economy or banking system. 

However, in the past few weeks more bad news has flowed from the banking industry. First to make headlines was JP Morgan Chase, one of the biggest banks in the US. It reported losses of US$2 billion (about Bt63.5 billion) from credit derivative transactions. Regulators promptly launched a series of investigations into the trading of JP Morgan executives. 

Lately several large banks have been investigated on the suspicion that they manipulated the London Interbank Offered Rate (Libor). One bank, Barclays, was fined US$450 million by UK and US authorities. This is the largest industry fine I have ever seen in my banking career. The Libor rate is a benchmark of interest rate on loans, which is agreed between London banks. The rate is fixed daily and acts as a guide for the rates of other financial institutions around the world. Banks will use the Libor benchmark to price loans to customers – you may be familiar with bank loans that calculate the interest rate as Libor + X per cent (per annum). The interest added on top of the Libor benchmark depends on the credit-worthiness of borrowers. Banks also use the Libor benchmark for derivative products like Interest Rate Swaps (IRS). In manipulating the Libor, banks would be able to take advantage of their counter-party. Following the fine for Barclays, the investigation continues to probe for other culprits of Libor fixing. 

What is happening to the banking industry these days? This is a question I have been asking myself and seeking the answer for. In my opinion, banking is a low-margin industry. When we extend loans we take a credit spread on top of our funding costs. On the other hand, we are taking deposits from public. Good borrowers are willing to pay a little spread, and depositors certainly want the highest interest rate. Some complain that banks take a big spread on personal loans, but that is to compensate the credit risk or potential losses. 

Meanwhile competition in the banking industry has driven margins down to the point where it is hard to take extra profits. Therefore banks need to find ways to compete by offering superior products, services and derivatives, and doing stock-market trading, to survive or increase returns to satisfy shareholder expectation. Sometimes it seems to me that we have taken excessive risks, and sometimes we have done it unethically. Thus, I would not be surprised if the banking industry came under tight regulation for years to come.

 

Views expressed are the writer’s own. 

 

Padej Piroonsit is head of Global Sales at CIMB Thai Bank.