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Libor probe tests regulators' faith in "Chinese walls"

Chinese walls | Libor probe tests regulators' faith in Ian Fraser

One of the biggest financial scandals of recent weeks involves the alleged "rigging" of Libor rates by a group of the world's largest banks. Some banks are understood to have lowballed their own borrowing costs in order to deceive investors and quell fears about their own creditworthiness as the crisis intensified in 2007-08.

The story first surfaced on March 15, when Brooke Masters, an assiduous journalist at the Financial Times, spotted the following on page 318 of UBS's 2010 annual report:

"UBS has received subpoenas from the SEC, the US Commodity Futures Trading Commission and the US Department of Justice in connection with investigations regarding submissions to the British Bankers’ Association, which sets LIBOR rates. UBS understands that the investigations focus on whether there were improper attempts by UBS, either acting on its own or together with others, to manipulate LIBOR rates at certain times ... UBS is conducting an internal review and is cooperating with the investigations."

In her FT report Masters suggested that a further 15 banks - including Barclays, Bank of America, Citigroup, Credit Suisse, Deutsche Bank, HSBC, JP Morgan Chase, Lloyds and RBS - might also have been  making up their Libor numbers. London Interbank Offered Rate is the rate at which banks are able to borrow money from each other and is used in financial markets as the prime benchmark for the world's credit/debt markets.

The FT splashed the latest stage of the saga in "Barclays at centre of Libor inquiry" on March 24. That report said:

"Barclays is emerging as a key focus of the US and UK regulatory probe into alleged rigging of benchmark interbank lending rates that are the reference point for $350,000bn in financial products...

Investigators are probing whether communications between the bank’s traders and its treasury arm, which helps set the daily London interbank offered rate, or Libor, violated “Chinese wall” rules that prevent information-sharing between different parts of the bank. Regulators require banks to put controls in place to prevent various arms of their business from profiting improperly from the flow of confidential information that other parts receive.

It would appear that "Chinese walls" are pivotal to the inquiry (although others have suggested this is a red herring). If Chinese Walls are key, this might be a turning point in how governments and regulators view the banking sector.

Investment and commercial banks like to pretend that such "walls" criss-cross their organizations, providing impenetrable barriers between functions like equities research and investment banking (oh, yeah!), between trading and treasury, between asset management and broking etc, etc. The idea is that it would be impossible for confidential information that might enable traders to insider deal to flow around the organization.

The reality, I'm afraid, is rather different. The "walls" aren't as sturdy as they sound. Privately some investment bankers admit that the barriers inside their organizations are hopelessly porous, more Japanese Shoji screen than Great Wall of China. They can be breached in many different ways (for example when an executive overhears a casual conversation in the elevator.) But with modern IT there are plenty of other ways too.

If the regulators' focus is Chinese walls in the current Libor probe, it would seem bizarre. As far as I am aware, acceptance and  indeed abuse of "conflicts of interest" has formed a key part of the investment banking model for at least one if not two decades.

The author Philip Augar, ex-City insider, highlighted this in his book The Greed Merchants: How the Investment Banks Played the Free Market Game. He argues that tolerance and indeed rampant abuse of conflicts of interest has lain behind the extraordinary profitability of the i-banking sector in the 1990s and Noughties.

In a blog post published in August 23, 2010, risk management expert Donald R van Deventer also said that "Chinese Walls" are far more mythical than real:

“Chinese Walls that are formed of human beings, not bricks, rarely work for long.”

Donald said the only group who still believes in the existence of the mythical barriers the regulators - and that the only reason they've kept their faith is that they don't relish the prospect of breaking up financial institutions which not only have they tolerated for years but which might one day offer them a job.

For me, this is one of the reasons why the wide-ranging Libor inquiry is so gripping. If nothing else, it's going to test the regulators' faith in "Chinese walls" to the limit. Without meaning to be too flippant might also test the capacity of the shredding machines inside those 16 banks to the full.

Further reading on conflicts of interest in investment banks and the effects of Chinese walls:

Tags: banking , banks , CFTC , Libor , regulation , Securities and Exchange Commission , UK , US
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