Issue: September 2012 / November 2012
Editorials

INTERMEDIARIES

Emotions run high

Banking behemoths have made themselves easy political targets. Trust, more than money, is the casualty. Ways must be found to restore it.


Diamond...first to fall
Fixing. Rigging. Lying. Manipulation. Scandal. A broad public who’ve never previously heard of Libor, much less understand it, buy into the headline epithets. Worldwide, they express outrage. They diminish trust in the institutions that mobilise national savings and underpin financial markets. People, sensing abuse, are handed a pretext not to save.

It goes beyond reputational damage for a narrow band of global institutions. All become tainted. On each occasion that one is fingered, it’s expected that there’ll be a next. By comparison with the big guns abroad, SA is blessed but not necessarily immune.

When confidence is lost in such household names as Barclays (and perhaps another dozen collusive banks yet to be pinpointed) over Libor, J P Morgan over shoddy risk management (senior executives oblivious to the billions lost in derivative trades) and most recently Standard Chartered over alleged disguise of sanctions-busting transactions, the earth moves.

When those running the institutions aren’t to be trusted, when obscene bonuses are reaped after taxpayer-funded bailouts that they themselves caused, there’s a stench of rip-off in the air. It’s conducive neither to the integrity of financial markets nor to the effectiveness of savings mobilisation.

No matter that SA pension funds are directly unaffected (see article elsewhere in this TT edition), except perhaps fractionally in so far as part of their offshore portfolios are hurt by the declines in share prices of the financial conglomerates abroad where they might be invested. Potentially, these overseas institutions could together face regulator-imposed fines and third-party damages claims larger than SA’s total savings pool.

Some of the world’s biggest money managers – Blackstar, Fidelity and Vanguard which collectively manage more than $7 trillion inclusive of some SA funds – are examining whom they can sue, and for how much, to recover client losses from the Libor manipulation. Charles Schwab, another big US firm, has already launched a lawsuit.

John Coates, Harvard professor of law and economics, is quoted in Pensions & Investments: “Libor-related litigation has the potential to be the biggest single set of cases coming out of the financial crisis because Libor is built into so many transactions and is central to so many contracts. It’s like saying that reports about the inflation rate were wrong.”

It’s not only the clients of investment firms allegedly hit by the rate manipulation; for instance, by depressed returns on their money funds. Private equity firms, whose deal financing is often based on the Libor benchmark, could be affected too. But it might be inordinately difficult for them to prove in court the particular damages caused by particular banks.

Regulators could also be in the firing line if it’s shown that they had advance knowledge of the rate fixing, yet condoned or even discreetly initiated it. Bob Diamond, dethroned chief executive of Barclays, has contended as much. Before the scandal burst, Diamond himself seemed not to realise how significant it would become. He thought the bank’s payment of a £290m fine, discounted because of his cooperation, would quietly end the matter. Now it’s a question of how many others will face even larger penalties.

Cool it, suggests the UK National Association of Pension Funds: “The impact of Libor manipulation is hard to pin down. It could have happened through a range of financial instruments. Pension fund trustees should ask their fund managers to tell them if and how their assets have been affected. Institutional investors like pension funds should be concerned about whether the commitment to improved risk controls has any real meaning.”

Barclays, so far alone, has admitted to the fixing of rates at artificially low levels. Depending on what eventually comes out in the wash, it might have been of far more to traders’ benefit than to investors’ detriment. One prominent UK investment officer told the FT that the consequences for asset owners would be “almost imperceptible”. Another pointed out that effects could be positive or negative, depending on the precise situation. For example, pension schemes with interest-rate swaps might have benefited from a lower Libor.

Clearly, the outcomes are more complex than the emotive headlines suggest. It goes beyond Libor, another stick to beat institutions that are essential intermediaries in the investment chain. As it’s been noted by John Kay, whose UK government-sponsored review was recently published (see Stewardship article), trust in the financial sector has reached an all-time low.

Yet trust is the essence of financial intermediation, he writes: “It is hard to see how trust can be sustained in an environment characterised by increasingly hyperactive traders, and it has not been.”

In the equities market, he continues, the chain of intermediation is long. It includes nominees, fund managers, fund of fund managers, insurance companies, pension fund trustees, retail platforms, independent financial advisors and more. As the chain is extended, the strength of any single relationship is diminished. Trust in the chain can only be as strong as trust in its weakest link.

To achieve the fundamental objectives of equity investment – high-performing companies that generate strong and sustainable returns for savers without undue risk – the intermediation chain should be shorter and simpler. “Most of all”, he argues, “it should be one in which rewards are earned through long-term relationships rather than frequent transactions”.

The applause at National Treasury in Pretoria is almost audible.