In his recent commentary on the LIBOR scandal, Jan Kregel elaborates on a distinction that is crucial to understanding this story.  The scandal centers around revelations that financial institutions had been manipulating their LIBOR rate submissions to the British Bankers’ Association (BBA).  Questions have subsequently been raised as to whether regulators were aware of and condoned, or actively encouraged, these manipulations.  But as Kregel explains, there were two very different types of manipulation that were going on, and the distinction between the two is acutely relevant to evaluating attempts to pin a major share of the blame for this scandal on regulators and central bank officials.  (LIBOR is a proprietary index put out by the BBA that is supposed to represent an average of the rate at which banks are able to borrow from each other short term.  It is composed of rate submissions from banks selected for a panel who are asked to give the rate at which they have borrowed or could hypothetically borrow.  The highest and lowest 25 percent of the submissions are thrown out.  LIBOR sets the benchmark for things like mortgages, student loans, credit cards, etc.  See Kregel’s piece for a more detailed explanation.)

Prior to the most recent financial crisis, LIBOR was rigged by banks in an attempt to benefit their trading positions (the banks had made bets whose payoffs depended in part on what was happening to LIBOR).  The investigative reports from the Financial Services Authority in the UK and the Commodity Futures Trading Commission and Department of Justice in the US point to evidence of such manipulation as far back as 2005.

But during the heart of the financial crisis there was a different type of misreporting going on, this time driven by the collapse of interbank lending.  While regulators appeared to have been aware of the latter misreporting, the evidence does not suggest they were aware of the former, more nakedly venal, pre-crisis manipulation.  A lot of the controversy on this question stems from a confused reading of the 2012 testimonies of Paul Tucker (currently deputy governor of the Bank of England) and Robert Diamond, the former head of Barclays Capital, before a House of Commons committee.  The testimonies are being read as providing the smoking gun evidence that the Bank of England was aware of the scandal from the beginning and failed to stop it—but this interpretation only works, as Kregel demonstrates, if you confuse or fuse together the two varieties of LIBOR manipulation.  And there are good reasons to keep them separate in our analyses.

The pre-crisis LIBOR manipulation was both up and down (sometimes of just a single basis point) and was rigged to boost trading profits, while during the crisis the misreporting was in one direction, and largely motivated by an attempt to avoid sending signals of funding difficulty.  The context in the latter case was a complete breakdown of markets due to the fact that short-term interbank lending had essentially seized up in October 2008.  Here’s Kregel:

If there was no trading due to collapse of normal trading conditions, then the submissions were clearly hypothetical, and little could be done about this problem. There could be differences in subjective assessments, as was the case with Barclays and other members of the panel, and there was no way to discern how far they differed from a “correct” representation. Barclays clearly believed that their assessments were more correct, but given that it had chosen not to receive direct government support, their higher borrowing costs may have been a reflection of this choice rather than due to errors on the part of other banks. But there is no way to know. The only other alternative open to regulators would have been to request suspension of the publication of LIBOR, which would have been much more disruptive of financial market conditions. And since LIBOR was a proprietary product of the BBA, the only avenue open to regulators would have been to suspend the use of LIBOR in financial contracts in a way similar to the Dodd-Frank suspension of the use of credit ratings in regulatory actions.

This is quite a different matter from rigging rates to increase trading profits.  But more importantly, as Kregel goes on to argue, these disputes over where to pin the blame are also serving to distract from much deeper systemic issues deriving from the existence of financial institutions that are too big to manage and too big to regulate effectively—of which the LIBOR scandal is yet one more piece of evidence.

Read Kregel’s Policy Note on the LIBOR scandal here.