"The basic structure of the world’s financial system has once again been exposed as fundamentally broken..."

Matt Yglesias:

You may not be interested in the Libor—the London Interbank Offered Rate—but the Libor is interested in you. Even though the typical American is never going to seek an interbank loan in London, the number is used as a benchmark for a wide range of other financial instruments.

Credit instruments with variable interest rates—private student loans, auto loans, adjustable-rate mortgages, credit cards, etc.—need to be indexed to some underlying marker of the overall cost of funds within the financial system. Often that’s something called the “prime rate” set here in the United States, but it’s also frequently the Libor.

So growing evidence that Libor numbers have been deliberately manipulated by banks for years means that millions of people have been paying the wrong interest rate on all manner of financial products. Vast sums of money have been wrongly snatched from innocent people and created equally vast undeserved windfalls for others. The basic structure of the world’s financial system has once again been exposed as fundamentally broken...

The real issue is just that international finance has become a ruthlessly competitive game in which firms relentlessly seek newer and bigger profit opportunities. At the same time, important swathes of the system are stuck in the days of the old boys’ club where important measures were handled essentially as gentlemen’s agreements. Setting the Libor through a fairly informal submission system and then using it as the basis for global interest payments created a massive arbitrage opportunity: Anyone who was willing to game the gentlemen’s agreement could arrange vast, riskless profits. And today’s cutthroat finance is nothing if not brilliant at arbitrage. In particular, it’s gotten frighteningly good at arbitraging away effective regulatory oversight. Time and again problems have arisen when clever bankers have found clever ways of undermining the intention of regulatory systems. The Libor malfeasance lays bare in an unusually clear way the basic fact that a modern bank is perfectly happy to lie when there’s money to be made. This has scandalized elements of the business establishment, especially in Britain, leading to a striking Economist cover image labeling the perpetrators "Banksters."

So far the shock waves haven’t really hit on this side of the Atlantic, but one can only hope they will. The United States enacted a major change in its financial regulatory system in 2010, but it’s not clear that we’ve yet had an adequate change in regulatory attitude. The lesson of Libor is that regulators need to recognize that bankers have cast aside the clubby values of yore, and they need to respond in kind. Banks will try to abide by the letter of the law, but where loopholes exist, they’ll be ruthlessly exploited—through dishonest means if necessary—and the financial cops need to have a fundamentally suspicious attitude toward the regulated entities. Time and again, when tighter regulation of trading is proposed, the concern is raised that stringency will push activity to foreign centers. In the short run, that’s almost certainly true. Banks will want to move to wherever they’re most likely to be able to get away with more shady dealings. But an economic development strategy based on turning your country into an appealing location for dishonest banking is just going to get you a financial system that’s rotten with dishonesty. It’s time to stop being surprised and start realizing that these are the inevitable fruits of a regulatory system that’s weak by design.