IGTA Journal - Summer 2018

financial crisis exposed excessive risk-taking and a long series of lapses in judgment, and the LIBOR scandal further undermined trust in the ethical standards of the banking industry. The scandal provides many cautionary lessons, including the ways in which poor technical design can be exploited, the limitations of self-regulation, the problems that arise when loyalty is to one’s trading co-conspirators rather than to one’s institution, and the need for robust controls. It also underscores the power of incentives to drive individuals and firms to do things that are imprudent and/or unethical . And, the governance and control framework that the banks and the LIBOR administrator had in place proved woefully insufficient to prevent misconduct that stemmed from poor incentives. In this context, one could say it was a situation ripe for exploitation. The openness and brazenness of misconduct as captured in the recorded transcripts also point to serious deficiencies in bank culture. My New York Fed colleagues and I have commented frequently on the need for sound culture and incentives as a complement to effective regulation and supervision. While there has been some progress on this issue in recent years, the LIBOR and other rate-rigging scandals—not to mention more recent breakdowns at individual banks— point to the need for further strengthening of bank culture . I look forward to the discussion with Minouche and Andrew on improving culture in the fixed income, currency, and commodity markets in the following panel. One of the key lessons from the financial crisis was that critical pieces of financial system infrastructure must be both strong and resilient, and the LIBOR scandal underscored this need . The essential problem with LIBOR is the inherent fragility of its “inverted pyramid,” where the pricing of hundreds of trillions of dollars of financial instruments rests on the expert judgment of relatively few individuals, informed by a very small base of unsecured interbank transactions. Moreover, that base has contracted further in recent years, due to many factors, including regulatory reform and the quantitative easing programs initiated by central banks in many of the major advanced economies. Relative to the vast sums of U.S.-dollar LIBOR contracts I mentioned earlier, the median daily volume of unsecured three-month U.S.-dollar wholesale borrowing is minuscule, at around $1 billion, and many days see less than $500 million in volume . This lack of market liquidity means that these rates cannot be sufficiently transaction- based to be truly representative, and rates that are not transaction-based are more at risk to be manipulated. So, despite efforts to improve LIBOR in recent years—and there undoubtedly have been important changes that have strengthened its administration and governance—the lack of underlying market liquidity for nearly all currencies and maturities remains a problem, and there is no obvious solution . The setting of LIBOR still depends heavily on expert judgment. Even for U.S.-dollar LIBOR, actual transactions are the basis for only about one-third of the rate submissions for tenors of one and three months. This is noteworthy because these are the maturities that are referenced by the bulk of financial contracts . In light of the history of LIBOR—and in the context of more than $320 billion in overall misconduct fines since the crisis—banks are naturally reluctant to assume the legal risks associated with submitting quotes based on very shallow markets . Indeed, that is why some banks have left individual LIBOR panels in recent years . Andrew Bailey drove home this point in his July 2017 speech. He explained that the Financial Conduct Authority had to press hard to persuade banks to remain on the panels and voluntarily submit LIBOR quotes through the end of 2021 . LIBOR’s potential cessation after 2021 poses a clear risk to financial stability, and prudent risk management means that all of us must prepare for a world without LIBOR. The Official Sector Response In recent years, international and domestic authorities alike have actively worked with the private 4 5 6 7 8 9 10 11 12 2 / 6 BIS central bankers' speeches IGTA eJournal | Summer 2018 | 47