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     Jun 30, 2012


Naked emperors, holy cows and Libor
By Chan Akya 

But the emperor - he wears no clothes," cried a little boy in the crowd. - Old fairy tale, or current newspaper headline.

One of the great benefits of traveling around Asia is the ability to spot habits that hark back to age-old traditions, some of which on closer examination point to a strong underlying scientific or economic basis (or both).

For example, devout Muslim communities across Southeast Asia eschew pork while neighboring Chinese communities feast on the same meat; this is because pork was economically wasteful and potentially harmful to human health in the Middle East where

 

Islam originated, while in the more temperate and rain-fed regions of Asia the economic arguments did not quite stack up - hence widespread pork consumption. There is no "right" or "wrong" in these traditions - merely that different peoples derive their habits out of distinctly different memories carried to them.

Then there are the "holy cows" of India, wherein a rising population in a deeply agrarian economy led to a mandated choice for calorie efficiency around grain-based diets, as against meat-based diets that simply proved unsustainable against the vagaries of the Indian monsoon.

One could easily imagine in the India of yore that if there had been two competing communities in a monsoon-fed region, over any 10-year cycle the community that chose a grain-based diet would have expanded in population rather more than the community that chose a meat-based diet; that's because a single crop failure would have killed off all the meat animals and in turn, the communities depending on the source of protein.

It is of course not only in Asia that such "holy cows" survive to this date; the political landscape has examples that highlight the effects of hidebound traditions that simply do not stack up in the modern world. The fires that started in Tunis last year and spread through the Arab world were the result of demographics as much as new technology - a younger generation of Arab youth simply didn't understand why they had to observe the niceties of keeping certain families in political power to lord all over them: in effect, an emperor's new clothes moment for the societies in Tunisia and Egypt.

Apocryphal perhaps, president Franklin D Roosevelt supposedly summarized the view of maintaining the status quo politically when describing then Nicaraguan president Anastasio Somoza - "he might be a son of a bitch, but he is OUR son of a bitch".

Ask any newly minted finance professional what are the holy cows in the world of finance and he or she would immediately point to more arcane and subtle stuff that rarely used to get to the front pages of newspapers: the fees of investment bankers ("7% of IPO proceeds"), secret codes of derivatives traders (the "11am Libor fix") and credit professionals (the "rating agency actions"). These are holy cows because while everyone knows about them - or think they do - it is also easily admitted that the procedures for actually replacing the conventions are mind-bogglingly difficult if not impossible.

Many a young banker has been sent home with a clip around their ear for asking to reduce fees on an equity market initial public offering in the name of competition. In much the same way, many an intelligent credit professional has argued against the use of credit ratings as the sole guide for quality; but their protests generally fell on deaf ears until of course it was all too late - as in the bankruptcy of Enron over 10 years ago or more recently the fracas around the "triple-A" rated United States mortgage market.

We don't even need to go that far - at least some readers will recall the opprobrium showered on this author when the rather sensitive topic of European sovereigns being unable to repay their debts was first raised in this column back in 2008. The article had posited the possibility that European sovereigns were not immune to going bust, anathema to legions of bond market traders who had imagined "credit" risk to be exclusively the preserve of non-government debt in developed markets and of course, government bonds in "emerging" markets.

What was truly interesting about those discussions, be it about investment banking fees or credit ratings, was the fact that everyone in the room generally acknowledged the intellectual points but always pointed out the apparent physical impossibility of changing anything about market conventions and practices.

None of these entrenched practices have any basis in capitalism or competition but represent the powers of oligarchical systems that helped entrenched interests to assume rent-collection roles in perpetuity, albeit not always by design. In so doing though, the rent-seeking behavior attracted its own legion of fans, who over time helped to maintain the status quo more or less unchanged: in other words, the Roosevelt doctrine on Somoza was reincarnated in financial markets.

The present scandal over the London Interbank Offered Rate (or Libor) and how this international benchmark for borrowing funds was manipulated by various banks to their advantage, like the fracas around credit rating agencies a couple of years ago, essentially comes around to the key point of how an oligarchy not particularly known for efficiency or efficacy managed to entrench itself. With US$350 trillion (as against global gross domestic product of some $50 trillion) in derivatives contracts written on Libor fixing, is it any wonder that someone somewhere thought it could be profitable to skew the system somewhat?

Even that attempt at cornering the fixes for banks to individually profit is not the main point of the Libor scandal. Rather, it is the sheer challenge of concocting an alternative that would help underpin the giant derivatives market and provide it with rate references that are altogether more transparent and tradable.

Going by the failed attempts to reform the credit ratings business over the past few years - a business that affects less than $10 trillion in bonds versus the derivatives market that stands some 30 times bigger - I wouldn't bet on the market's ability to find a replacement.

Much like learning to live with the Saudi royal family due to an apparent paucity of alternatives, global policymakers and market makers will have to learn to live with the seriously twisted Libor and credit rating businesses for a long time to come. An Arab spring for the markets isn't on the cards.

Dedicated to Tony Allison
The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore, all progress depends on the unreasonable man . George Bernard Shaw

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(24 hours to 11:59pm ET, Jun 28, 2012)

 
 


 

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