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The One Possible Bank Defense In The Libor Scandal, And Why It's Bogus

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Here's a free PR campaign idea for the banking sector: Big banks helped the economy, maybe saved your job, with some of their blatant Libor-market cheating.

But like most bank PR campaigns, it's not even a decent half-truth: The full truth is, we risk ever-bigger economic blowups in the future, and utterly wrecking our trust in financial markets, if we let this sort of behavior continue.

In the days since the Libor scandal broke big, one question keeps getting asked: Why aren't people more outraged? As Matt Taibbi put it, why aren't people freaking out about the fact that Libor, an interest rate that affects borrowing costs for homeowners and businesses the world over, was as fake as Bruce Jenner's face?

One obvious answer to that question is that it involves math, and math is hard for us!

Another answer, the one that has made many on Wall Street fairly blase about the whole thing, is that this looks at first glance like a victimless crime. Banks are mostly accused of setting Libor too low, to make themselves look more healthy and less like they were about to be choked off from the financial markets.

If this is true, if banks systematically cheated to make Libor look lower than it really was, then borrowers throughout the economy benefited. Your adjustable-rate mortgage, business loan or corporate bond was a little cheaper because of those cheating banks.

Which is why you could imagine central banks mostly looking the other way when the Financial Times, the Wall Street Journal and others raised alarms years ago about the possibility that Libor was a rigged game. In fact, Barclays kinda-sorta argues that the Bank of England kinda-sorta told it to manipulate Libor lower.

After all, the Federal Reserve, Bank of England and other central banks around the world are also manipulating interest rates. All the time. Except when they do it, it's called "monetary policy." When Barclays does it, it's cheating.

If they wanted to fight back, the banks could very well react to this scandal like Jack Nicholson's Colonel Jessup in "A Few Good Men." To paraphrase Aaron Sorkin:

"You want the truth about Libor? You can't handle the truth. We live in a world economy that has walls, and those walls have to be guarded by banks with interest rates. You weep for Libor, and you curse the banks. You have that luxury. You have the luxury of not knowing what the banks know. That Libor manipulation, while tragic, probably saved jobs. And the banks' existence, while grotesque and incomprehensible to you, saves jobs."

That could be the banks' defense -- except it would be full of crap.

For one thing, Barclays -- and almost certainly other banks -- were manipulating Libor rates well before the crisis struck. In some cases, nobody knows how many, they manipulated Libor higher, potentially costing borrowers money.

That may not have been a vast sum of money: The Economist suggests Libor rates were not all that out of kilter with other borrowing costs before the crisis. So if banks were cheating with Libor, they weren't cheating in a very noticeable way.

Of course, any teenager sneaking sips out of his parents' liquor cabinet can tell you that you don't just guzzle down whole bottles. The folks will notice if you do that. You do it a little bit at a time, so that nobody notices.

The banks may still be cheating Libor lower, helping the economy, but we can't trust that will always be the case. As soon as the economy recovers a little bit, and demand for loans rises, the banks will have incentive to raise borrowing costs.

And banks will always have an incentive to cheat Libor higher or lower, depending on their position in derivatives markets. Libor affects some $350 trillion in notional credit derivatives. That's $350 trillion reasons to cheat.

More critically, the main lesson from this scandal is that these big banks cannot ever be trusted to police themselves.

The whole system for Libor relies on this misguided trust: We leave the setting of this critical interest rate up to the world's biggest banks and their self-diagnosis of their own financial health.

It should have long ago been plainly obvious that this was not going to work. Maybe in some parallel universe, where banks are run by Care Bears tripping on LSD, you're going to get banks reporting these rates honestly every time. But in our imperfect world, banks have an almost daily interest to set Libor incorrectly, either too high or too low.

We obviously need to fix Libor, possibly by coming up with some sort of market-based borrowing rate, even if that makes borrowing costs go higher in the short term.

But we also need to give up our naive trust that banks will do the right thing: A trust that affects not only the Libor market, but also the Federal Reserve's primary dealer system, notes David Kotok of Cumberland Advisors. That lays the groundwork for many, many more scandals.

Since creating the financial crisis, the banks have pushed back against tighter regulations and limits on their size and scope, warning of grave threats to the economy if we regulate them too much. See Dimon, Jamie and Baby, Bathwater.

The Libor scandal is a reminder that there's no bigger threat to the economy than a too-big-to-fail bank doing whatever it wants to do.