The LIBOR scandal will be a field day for our learned friends. An estimated $350 trillion worth of financial instruments is tied to the benchmark interest rates. The potential cost of litigation against the banks from those who own and trade those swaps and other securities that were priced using LIBOR could be substantial, as will be the legal fees involved. Contingent provisioning against that has yet to be fully priced into bank stocks.
Barclays’ settlement with U.K. and U.S. regulators over LIBOR rigging is just the start. Several other international banks are still being investigated by authorities. Heftier fines than even the £290 million ($450 million) one imposed on Barclays are quite possible, as will be taking away LIBOR-setting from the hands of the bankers themselves. No longer will it be the responsibility of their industry group, the British Banking Association. That latter step will be part of an urgent rebuffing of London’s reputation as a transparent internal financial centre that will need to be undertaken by the U.K. authorities.
One other consequence of the LIBOR scandal will be to make U.S. lawmakers even less inclined to embrace international financial regulation. It will be argued that benchmark interest rates that affect American consumers and investors should be regulated at home, even if many in the U.S. Congress had been blissfully unaware of LIBOR until very recently.
Has there been a subtle shift of emphasis within the club of international bank regulators from primarily protecting depositors in failing banks to insulating taxpayers from the costs of public bailouts, or at least shoving them behind shareholders in the queue? The new restrictions on banks’ hybrid securities announced by the Basel Committee on Banking Supervision earlier this month suggests there has. They follow a broader clamping down on banks using preference shares and other forms of debt as a cut-price way to shore up their regulatory capital, all of which will be phased out under the Basel III banking-reform proposal.
Hybrid securities have characteristics of both debt and equity. They were intended to serve as an alternative source of capital to public bailouts when a financial institution got into trouble. Banks like them because they are a cheaper way to raise capital than equity; an estimated $1 trillion worth are in issue. Existing rules let failing banks count some hybrids as Tier 1 capital and so shield investors from losses that taxpayers then had to pick up through bailouts; the new rules close that loophole from the start of 2013 by requiring that hybrids trigger an automatic conversion to equity (a bail-in) or a write-off in the event of a bank becoming ‘non-viable’ and needing an injection of public capital.
Non-viability is a new regulatory concept that has fallen out of the 2008 global financial crisis and has yet to crystalize into firm meaning in national rules and regs. Plenty of arguing over its implementation to come, you can bet — and plenty of bleating by banks in developed economies that this will increase their cost of capital and so make them less able to lend. But with the need to convert existing hybrid’s into compliant securities within a couple of years (and to harvest the considerable fees that will involve), those conversations will have to be cut short. Investors in hybrids will find themselves pushed down the queue regardless.
The devil is usually in the detail. The detail that matters with America’s newly passed financial reform legislation will be the rules and regs yet to be written and the appointments made to oversee the writing and enforcement of those rules and regs. Congress has passed a broad set of instructions to regulators but left, let us say, 75% of the work still to be done over the next four years. That leaves plenty more time and scope for the financial services industry to lobby to water down the provisions of the Restoring American Financial Stability (RAFS) Act still further.
As it is, the act does little to reduce systematic risk. The work being done on capital requirements, liquidity and leverage limits by the the G20’s Financial Stability Board to create global standards for systemically important financial institutions is likely to prove to be of more lasting significance in that regard.
Legislate first, regulate second is not novel in the U.S. Sarbanes-Oxley, the corporate governance legislation hastily enacted by Congress in 2002 in the wake of the WorldCom and Enron scandals, was similarly broad-brush. That its subsequent rule making was in line with the strict spirit of the legislation owed much to the presence of an activist chairman at the Securities and Exchange Commission in William Donaldson.
RAFS will involve many more regulatory agencies than just the SEC, offering not just a less natively uniform regulatory landscape but all the more opportunity for the financial services industry to divide and rule. Banks have already weakened in the act the impact of the proposed Volker Rule to limit their proprietary trading. Their next step will be to expand even further through rule making the types of proprietary trading they are allowed to undertake. The exemption for proprietary trading on behalf of customers gives them a massive loophole to start from. Similarly, banks will be lobbying to keep a growing range of bespoke derivatives trading off-exchange, while making sure new rules for trading standardized contracts on-exchanges aren’t too burdensome.
One area where there will be less scope for post-legislation tinkering is the new Consumer Financial Protection Bureau, which has been uncharacteristically tightly and narrowly drafted by the standards of the rest of the RAFS Act. Who gets appointed as its head and their skill in negotiating the Washington bureaucracy will be key. But even before then, as the president gets to nominate the candidate but the Senate has to confirm him or her, the tenor of consumer protection within financial services could turn on November’s mid-term elections as much as anything.