Rot of corruption in banking industry poisons investors

The Libor debacle is merely the latest in a series of abuses since the 1990s that include dodgy derivative trading, fraudulent personal protection cover and predatory lending as part of the sub-prime mortgage fiasco.

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Barclays' global ignominy proceeds apace. The UK-based banking corporation stood down this week from the UAE's Central Bank panel that fixes Eibor, the Emirates' interbank lending rate. This comes just two weeks after Barclays was given record fines of $453 million (Dh1.66 billion) by UK and US regulators for manipulating Libor, the London equivalent of Eibor, both in the run-up to the 2008 global financial crisis and in its aftermath.

The Barclays rate rigging that triggered the resignation of its chief executive Bob Diamond is part of a scandal that involves much of global banking and finance. Libor is made up of banks' daily estimates of their borrowing costs, which influences the costs at which they lend. As such, Libor serves as a benchmark for the borrowing and lending costs of mortgages, loans and derivatives that are worth more than $450 trillion worldwide.

Separate investigations by independent US and UK regulators have uncovered the sheer scale of manipulation. In one email sent to a Barclays staff member involved in the bank's Libor estimate, a trader asked for the rate to be set "as high as possible today". The employee simply responded "sure" and was promptly promised a bottle of vintage champagne for his troubles.

Nor is this a recent discovery. A cache of documents released last Friday by the New York Federal Reserve shows that Timothy Geithner, then the head of the NY Fed and currently US Treasury Secretary, knew since April 2008 that Barclays was misreporting its Libor submission. The Bank of England governor Sir Mervyn King acknowledged such concerns at the time but denied any evidence of wrongdoing at Barclays.

Since Libor is based on an average of 16 banks' public submissions to the British Banking Association, Barclays is unlikely to be the only villain in this plot. That is why some of the largest US, UK and European investment banks are currently being investigated as part of the Libor probe, including state-backed lenders Lloyds Banking Group and Royal Bank of Scotland. Regulators either turned a blind eye or lacked effective powers to confront manipulative banks.

Banks have benefited from rigging interbank lending rates in two ways. First, regulators are said to have tacitly encouraged banks to underreport their borrowing rates during the credit crunch of 2007-08 for fear of triggering a panic. By understating their own financial trouble, banks "too big to fail" escaped from being part-nationalised.

Second, published correspondence between Barclays and regulators shows that banks submitted excessively high interbank lending rates in the aftermath of the crisis. They increased their profits by passing on the "extra costs" to their customers.

In each instance, ordinary savers, borrowers and taxpayers were the great losers: subsidising bank profits by getting less for their savings and paying over the odds for loans. In this way, tens of billions that ordinary people might otherwise have saved on their borrowing or received on their lending went to banks instead.

The Libor debacle is merely the latest in a series of abuses since the 1990s that include dodgy derivative trading, fraudulent personal protection cover and predatory lending as part of the sub-prime mortgage fiasco. Every time traders privileged short-term profits for the few over longer-term prosperity for the many.

These abuses undermine the primary function of banks, which is financial intermediation: linking savers to investors and generating growth by connecting finance to the real economy. Rather than channelling savings into productive investment, banks have made yet more money out of money.

So instead of a free market and competitive prices, global finance is dominated by a cartel of large banking corporations that have manipulated interest rates and engaged in price-fixing. In the process, they have had an all-too-cosy relationship with credit agencies and have colluded with both governments and regulators.

Crucially, bankers have divorced risk-taking and rewards from responsibility. Either they make a killing from high-risk trading or they walk away with multi-million pay-offs when things go horribly wrong. This culture has produced a system that privatises profits, nationalises losses and socialises systemic risk.

What is to be done? The incentive and reward structure of global banking needs to shift from encouraging fraud for short-term gains towards inflicting long-term pain on reckless behaviour.

On interbank rates, banks submitting an estimate that differs markedly from their actual lending or borrowing costs should pay fines for a false submission. Pay and bonuses must reflect sustained success, not just annual profits. If convicted, bankers should pay out-of-pocket fines, do jail time or be struck off the register. Why treat them differently from doctors or lawyers?

In 2008, governments rescued the world economy from collapse by saving the banks that were "too big to fail". Less than four years later, governments must save the world economy from stagnation and depression by breaking up the banks that are "too big to bail" and impossible to regulate at arm's length.

Adrian Pabst is lecturer in politics at Britain's University of Kent and visiting professor at the Institut d'Etudes Politiques de Lille in France