By Megan Bowman, UNSW

SYDNEY: 26 March 2014 – This week CLMR commenced the first of four major workshops on regulatory issues regarding the manipulation of the London Interbank Offered Rate (LIBOR) and associated benchmarks. The aim of the first workshop, held at Allens Linklaters in Sydney on 26 March, was to map the scale of the regulatory problems. The second workshop will be held at Harvard University in May to evaluate divergent enforcement agendas with particular reference to the European Union Competition Directorate investigation into how traders at contributing banks operated as a cartel. The third workshop will take place in London in September to evaluate the degree of success that investigations and regulatory initiatives regarding currency manipulation by the International Organisation of Securities Commissions (IOSCO) and the Financial Stability Board (FSB) have had in engendering confidence and curbing malfeasance. The final and fourth workshop will return to Sydney in November concomitant with the G20 Leaders Summit. The papers from each workshop will be published in special editions of the Law and Financial Markets Review which is a highly regarded academic journal published by Hart, Oxford and edited by CLMR Director Professor Justin O’Brien.

Guiding themes for the first workshop arose from the truism that regulators tend to create new rules to rebuild trust and confidence after a crisis; yet reactive regulation that is ill-considered in design or implementation can generate high compliance costs and exacerbate adversarial tensions without necessarily reducing risk. The scandal surrounding the long-term manipulation of the LIBOR reveals that crucial yet covert obstacles to countering entrenched and deleterious elements of the global finance system may be normative as well as  technical.

Thus, regulating against the harmful effects that may be nurtured by elements of the prevailing culture of the finance sector is one of the greatest challenges facing contemporary society.

Having regard to these challenges, seven expert speakers mapped the rocky terrain of the LIBOR scandal and its aftermath in the first workshop. These speakers were Mr Greg Medcraft, Chair of the Australian Securities and Investments Commission (ASIC) and IOSCO; Martin Wheatley, CEO of the UK Financial Conduct Authority (FCA); Dr Deen Sanders, CEO of the Australian Professional Standards Authority (PSA); Professor Eric Talley from the University California (Berkeley); Professor Justin O’Brien and Dr George Gilligan from CLMR UNSW Australia; and Mr John Morgan, Partner at Allens Linklaters. The audience was at full capacity with a diverse composition of bankers, regulators, lawyers, academics and journalists.

From the perspective of cultural regulation, some key challenges arise when harmful behaviour is not technically illegal. Mr Wheatley stated that the pre-2013 UK regulatory structure under the Financial Services Authority (FSA) was “ill-equipped” to deal with something of the scale and ilk of the LIBOR scandal. Specifically, he said that the scandal “erupted outside the regulatory perimeter” in the sense that the definition of market misconduct at that time did not extend to the submission of interest rates cost of borrowing.  Mr Wheatley said that every regulator had a problem regarding dealing with conduct that is “obviously abuse” but not illegal such that “depending on the ethical model of the jurisdiction in question, manipulation may not technically be illegal.” 

To this end Mr Wheatley stated that the new FCA which began operating on 1 April 2013 has a “completely different philosophy” to its predecessor: “the focus is now on forward-looking regulation not backward looking, on compliance models not box ticking, and on an ethics of care not an ethics of obedience.”

Importantly, this change in focus amounts to a significant philosophical and cultural change within the regulator itself. And it is clearly a harbinger of cultural change that the FCA would like to see adopted by regulatee organizations. Scandals can take a long time to come to light precisely because harmful behaviours may be viewed as acceptable and normal by market participants.

To this end, Mr Morgan’s contention that those who price risk might influence organisational behaviour is novel and powerful. The three major types of indemnity insurance are fidelity/prime cover (such as for embezzlement), professional indemnity (civil liability) and director liability (primarily criminal). Instead of focusing on moral hazard, Mr Morgan highlighted that the cost of premiums could be an under-used regulatory lever by which to improve cultural standards within capital markets actors. Mr Morgan opined that this may be a particularly useful way of influencing behaviour and culture within smaller banks.

In addition to regulating a firm’s culture via external monitors (such as insurers), individual practitioners within a firm, particularly those at the coalface, can be targeted as well as senior management or ‘the firm’ itself. Indeed, Dr Sanders promoted the professionalization of financial services as a potential puzzle piece in the broader regulation of market conduct. Specifically, he argued for the need to balance public good with economic benefit and to recognise the role and responsibility of the professional individuals (not their corporate entity) who are “sitting opposite and advising” individual consumers. However, he noted the current milieu of employer primacy, which creates regulatory gaps in professional standards.

However, as Professor O’Brien and Dr Gilligan pointed out, a principles-based approach to regulation will not have traction with market players that do not have principles. Speaking to the issue of rogue traders, rogue regulators and state actors as policy entrepreneurs, O’Brien and Gilligan argued that renewal and reform are likely to fail unless the core ethical deficit at the heart of contemporary banking is systematically addressed. On this point, employees and their firms are indistinguishable: corporate culpability for individual ethical failures is invariably and inevitably informed by the relative strength or weakness of the firms’ organizational culture. Culture and resulting behaviour are reinforced through recursivity and reciprocity between individuals within a firm, senior management of a firm, and the firm’s macroeconomic political context.

Accordingly, a clear (and largely unspoken) dilemma occurs when regulatees, whether firms or individuals, behave complicitly not just with each other but with the government regulator itself. Professor Talley, who presented the view from North America on LIBOR and the dynamic of US regulatory politics, conducted empirical research that revealed a correlation between regulator and bank behaviour at key moments in time. The clear implication from these data is that the U.S. regulator knew about the benchmark manipulation and chose to ignore it. If this was the case then should we be concerned? From a public policy perspective the answer is both yes and no. The regulator has a mandate to ensure market confidence. This can be done by punishing wrongdoers and sending a strong signal about appropriate market conduct to all market participants. Yet it can also be achieved by mitigating market hysteria in times of crisis. Ironically, any government complicity, if it existed, may have been motivated by a public welfare logic.

In conclusion, the LIBOR scandal presents a doorway through which we can glimpse the secret garden of market conduct and financial regulation: currently overgrown with weeds but with significant landscaping potential. Arguably there is no one perfect solution; yet for this very reason now is the perfect time for regulatory experimentation and pluralism. This will need to include deeper consideration of modalities for regulating culture, industry self-regulation, and inculcating an ethics of care and not obedience into both regulator and regulatee thinking and practice.