An Epidemic of Price Fixing in the Financial Markets

Nothing is more antithetical to the principles of free enterprise than price fixing.  Rigged prices undermine the efficient functioning of markets and defeat their ability to maximize economic welfare.  Sadly, we've had an epidemic of price fixing in the financial markets, frequently involving the largest and most important banks.

The London Interbank Offered Rate has been the subject of governmental investigations in Europe and the U.S. for alleged years-long collusion. Billions of dollars of fines, penalties and other payments have been assessed on various big banks, and the investigation of other major banks continues.  Trillions of dollars of loans and contracts were priced based on Libor, and the potential impact of this price fixing is massive.

Foreign exchange rates have been investigated for rigged prices, and billions of dollars of fines, penalties, etc. have been paid in government and private civil lawsuits.  Again, some of the largest banks are implicated.

Now, word comes that the market for interest rate swaps has been under investigation for price fixing via the alleged collusive manipulation of the ISDAfix, a benchmark swap rate that is used in the pricing of a variety of financial products.  The interest rate swaps market, although obscure to the general public, involves hundreds of trillions of dollars of financial products (in notional value) sold to corporations and other commercial customers to offset interest rate risk.  Big banks are reportedly involved this collusion and the fines, penalties, etc. could total perhaps billions.

There are also reports of investigations of price manipulation by big banks in the metals markets.  These might involve restricting supply and other maneuvers to rig prices.  If wrongdoing is uncovered, more large fines, penalties, etc, can be expected.

Many of the banks involved in these matters are likely to be too big to fail.  In other words, while conspiring against the public in very large and important markets, these banks enjoyed the explicit and/or implicit backing of the taxpayers.  This backing helped them attain Brobdingnagian size, which in turn probably facilitated their ability to rig markets. 

The financial markets are the central venue of the capitalist system, being the place where holders of capital and borrowers of capital meet to determine the allocation of society's financial resources.  The largest banks are at the center of the financial markets, and their conduct ripples through the financial markets and the entire free enterprise system.  That such crucially important players are so regularly conspiring against the public and the public interest presents a galling spectacle that damages the credibility of the capitalist system.  Are markets truly socially beneficial or are they simply a means by which the rich and powerful fleece others? 

The world's largest banks have the legal and social responsibility to refrain from such reprehensible conduct.  However, their sad record of massive, multi-market price fixing seems to tell us that their chances of upholding these responsibilities aren't very high.  Their collusive activities often arise in markets that have a bi-level structure:  an inner inter-dealer market where the big banks and other financial firms trade among themselves, and an outer market where the dealers trade with the public at usually marked up prices.  The inside inter-dealer market is a perfect venue for price-fixing, as the dealers have to talk and trade with each other every business day.  As Adam Smith put it in The Wealth of Nations, "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices."

Thus, the challenge falls on regulators and law enforcement authorities to be vigilant and firm.  The sheer magnitude of the wrongdoing, as demonstrated by the billions that have been paid out to date, is astonishing.  Those who may seem paranoid about the financial markets have it right--way too often, the markets are rigged.

More Badness in the Bigness of Banks

The problems presented by gargantuan banks aren't limited to just too big to fail.  In recent months, we have seen government investigations and enforcement actions dealing with price fixing by big banks in interest rates (LIBOR), foreign currencies, oil and other commodities.  Cartels and oligopolies are antithetical to free enterprise.  To make things worse, the things that were the subject of the conspiracies--benchmark interest rates, petroleum, and the value of the medium of payment in various countries--affect the prices of numerous contracts, investments, products and other things.  Thus, the impact of the price rigging ripples through national and international economies, with the result that a lot of things aren't accurately priced.

The size of the mega banks allows them to dominate these markets.  The small number of players involved makes collusion easy.  It's hard to rig markets with dozens or hundreds of competitors.  But a few big dogs readily find it more profitable to stack the deck in their favor and reap monopolistic returns than compete with lower prices.

Collusion deprives consumers, investors and others of the benefits of competition and efficient markets.  The oligopolists are richer by their financial hooliganism.  The rest of us are poorer.  When banks are too big to fail, governments--and ultimately taxpayers--prop them up.  It would appear that the big banks return the favor by rigging prices.  It's getting harder and harder to see the societal benefits of really big banks.

How To Stop the Too Big From Failing

Congress, and financial regulators in America and other nations, have struggled endlessly with the problem of financial institutions too big to fail.  Capital requirements have been increased, and regulation has been tightened (somewhat--much of the implementation of the Dodd Frank Act remains unfinished).  But the problem remains.

There is a simple way to seriously reduce the possibility of another taxpayer-funded bailout.  If a financial institution needs a government bailout, force the CEO, COO and CFO, and the members of the Board of Directors, to pay to the government the value of their entire compensation for the preceding five years.  This would include salary, bonuses, stock options, restricted stock, fees, country club memberships, company cars, and all other perks and compensation.  This payment would be required without regard to whether or not the executive officer or director was proven to have participated in any wrongdoing or neglect.  It wouldn't be a penalty for misconduct.  It would be an incentive to avoid sticking the government with the costs of mismanagement.

Any such proposal would, of course, provoke howls of outrage from financial institutions and their free-roaming packs of mouth-foaming running dog lobbyists.  Such a measure would be unfair if the officer or director hadn't been shown to have engaged in misconduct, it would be argued.  However, the SEC already has the legal authority to force a company's CEO and CFO to pay out all their compensation for the 12 months following the issuance of financial statements that are subsequently modified (in a form called a restatement)--see Section 304 of the Sarbanes-Oxley Act.  The SEC isn't required to show that the CEO and CFO did bad things.  They can be forced to make this payout simply because the original financial statements were wrong and needed to be restated.  The courts have upheld this authority.  There's nothing unfair about requiring senior executives to get important things right in the first instance.

Banks and other financial institutions might also object that they couldn't recruit the executive talent they need if this financial Sword of Damocles were to hang over their heads.  But, when we consider the geniuses at some financial institutions in the recent past who steered their firms right over cliffs and into government safety nets, this argument loses its persuasiveness.  Executive compensation arrangements at the too big to fail seem to incentivize risk-taking, even if it might entail unmanageable complexity.  There needs to be a disincentive--and a strong one.

The government has been criticized for not penalizing the high and mighty for the financial crisis of 2008.  Remember, however, that the statutes and regulations governing financial institutions are complex.  Proof of violations can be difficult.  A simple measure like a penalty of five year's compensation for a government bailout offers a way to nail the top dogs for signing a chit the taxpayers have to pay.

Why Wall Street Should Oppose Too Big to Fail

The too-big-to-fail doctrine, now at the heart of the administration's proposal to reform financial regulation, might seem the best of all possible worlds to the big banks on Wall Street. They can take all variety of risks, speculating in this and dabbling in that, yet their obligations are guaranteed 100% by the U.S. government. Anyone and everyone will trade with them--and indeed at favorable prices--because they cannot default. Their borrowing costs will be barely above comparable Treasuries, but their profits have no upper limits. Although the administration and the federal banking authorities rumble about pay limits, that's why you have lawyers. There's never been a lawyer who didn't see a loophole or five in the law, and the highly compensated counsellors who serve the carriage trade will burn the midnight oil so that they can find every tiny crack in the regulatory structure, figure out how to drive a tractor trailer of compensation through it, and bill their clients handsomely in the process. And should there be a scarcity of loopholes, the canine-toothed lobbyists on K Street will whip out their checkbooks, already preprinted to be payable to (blank) Re-election Campaign, and make Swiss cheese of previously solid law.

But sometimes, something that looks almost too good to be true is too good to be true. The too-big-to-fail policy, already implemented by the Federal Reserve and Treasury Dept. on a de facto basis, has created a cartel of financial oligarchs. These megabanks derive significant market advantages from their favored status, and have reported commensurate profits. But the backlash has already begun. Their compensation policies are under severe scrutiny. Counter-intuitively, Citigroup had to sell what was perhaps its most profitable unit, the commodities trading operation that was supposed to pay its head trader $100 million this year. Those banks with credit card operations are losing significant revenue streams as new legislation increasing consumer protections restrain the gouging of struggling customers. Leverage is being limited to a debt-to-equity ratio of something around 10 to 1, compared to 30 or 40 to 1 during the halcyon days before Lehman collapsed. Leverage limits will slow profit growth, which will eventually affect employee compensation. The employees that enabled banks to act like hedge funds will gradually migrate to real hedge funds, because the big bucks for MBAs aren't in opening passbook savings accounts. Personnel are the only true assets of any bank that wants to be an investment bank, and this migration will drain away the people who provide the sparkle to bank profits.

The future only promises more government presence among the big banks. The soon to be created federal agency/council/czar/doyen or whatever (hereinafter, the "uber-regulator") that will manage systemic risk may turn out to be much more intrusive than the big banks think. To do the job of systemic risk management properly, the uber-regulator will need shiploads of data, much more information than bank regulators now collect. The federal bank regulators were blind-sided by Bear Stearns, Lehman and AIG--they didn't know how massively these firms were inter-connected and intertwined with everyone else in the world of finance. In order to avoid replaying these really scary videos, the uber-regulator will have to know how deeply intertwined and inter-connected the big banks are. But that won't be enough. One would have to dig into the next layer of counterparties, find out who they are, and how vulnerable they would be if one or more of the big banks went down for the count. The counterparties might not like this, but the uber-regulator would have no choice. The reason AIG got its blank check bailout was that the Fed and Treasury belatedly learned, post-the Lehman bankruptcy, that AIG was deep in a vat of liabilities owed to everyone that mattered in finance. This is information the uber-regulator would need on a regular basis--you can't wait until the toilet is flushing to get the information. You need it now, before the crisis, in order to prevent system-threatening conduct. And going to the first layer of counterparties may not be enough. One might have to look into the counterparties of the first level counterparties, and then their counterparties, and so on, to find out how much liabilities loop back to the big banks and other interesting things. The financial services industry has turned itself into a dense thicket of inter-connectedness that beats Facebook, My Space and the rest of the world of social networking by an exponential factor of 100. The uber-regulator will have to dive into granular details in order to do its job properly. Numerous lightly regulated financial players might soon find themselves receiving routine visits from skeptical federal examiners. That might put a damper on their exuberance.

And if the dicier--and potentially more profitable--stuff moves off shore and away from federal jurisdiction, guess what will happen? The uber-regulator and probably other federal regulators will tell the financial oligarchs to stay away from it. Passbook savings, CDs and credit cards will have to suffice as product lines.

GM might eventually get out from underneath the federal thumb by repaying the money it's borrowed from the government. We taxpayers all hope it does. But the financial oligarchs can never escape the federal grip, because they'll always be too-big-to-fail. Unless they make themselves not so big, such as through strategic divestitures and spin-offs. Or by opposing a federal policy that could easily make them more regulated than they ever thought possible.

The free enterprise system doesn't exist without the possibility of failure. If failure is abolished, we end up somewhere between Socialism and Communism. The federal government should allow major financial institutions to fail but try to limit the collateral damage. Given that AIG's creditors received 100 cents on the dollar, it would have been no more expensive to allow AIG to go down the drain and write checks to its creditors for everything AIG owed them. AIG's senior management would have been out of jobs, and deservedly so. Many and perhaps most of its employees would probably have kept their jobs since the operating insurance subsidiaries of AIG are mostly sound and could have been sold off or established as free-standing businesses. The end result would have been a better outcome, and we would perhaps be having less of a handwringing experience in formulating reforms for federal financial regulation.