There’s mischief afoot. Well, at least there was. For the last week the press has been reporting that from 2005 to 2007, and again in 2009, the LIBOR was manipulated by Barclays, and potentially 14 other banks. The rate was first manipulated to be higher, and then, during the financial crisis, it was pushed artificially lower to make the banks look more stable.
Although the media has been very focused on the issue of trust and our financial system, which is key to the whole scandal, we thought it would be interesting to look at it from a different direction. How will the scandal affect private capital transactions?
1) More conservative banking and growth in alternative lending
The biggest potential issue stemming from the scandal is the ongoing investigation of the other 14 banks who may have also been involved in manipulating the rate. Barclays was the first bank targeted and their CEO resigned when the investigation uncovered blatant manipulation. What happens if 7-10 other CEOs resign from the most well-known banks in the world?
Regime changes often mirror changes in company cultures. There could be a drastic shift towards more conservative banking as future CEOs will take high-profile posts under the fire of scandal. They will be focused on keeping their banks out of the news and sticking to strict internal guidelines, including potentially restricting loan terms or increasing requirements.
If the terms get tighter at the best banks, mezzanine and other lenders who sit in the middle between banks and equity investors could benefit. Over the last few years, as banks have been unwilling or unable to loan money, alternative lenders like SBICs have been popping up to fill the gap. The scandal could potentially make that gap wider, leaving the window for growth in alternative lending open longer.
2) Political implications and new laws
The second issue with the LIBOR scandal is that it perpetuates existing fears of finance and banking sector as a whole. Since the financial crisis four years ago, we’ve seen ongoing scrutiny of finance, from books like Too Big to Fail and The Buyout of America, to legislation such as Dodd-Frank. Mitt Romney’s run for president has pushing private equity into the spotlight. Everything he did at Bain is fodder for Obama’s political campaign and even his tax returns have stirred up debates about carried interest.
While the implications here aren’t direct, the LIBOR scandal could be one more piece of evidence that helps push legislation through Congress. If a law like the carried interest bill made it through the House and Senate and significantly affected the profit margins for private equity, it could change the investments by endowments, pension funds and other large investors that fuel much of the industry. This is a lower probability event, but the LIBOR scandal just adds to an already vilified image of the financial industry.
3) Direct Implications
The real news here is that there really isn’t any news, at least not for small businesses and private equity groups. The rates they’re receiving on short term loans today aren’t affected by the scandal that happened three years ago. While the LIBOR is the most widely used index for pricing variable securities, including roughly $800 trillion in derivatives, mortgages and loans, the current rate is so low that any pricing issues at the time of the scandal are fairly irrelevant.
The only real incentive for banks to manipulate the LIBOR rate is to affect the perception that the bank is more solvent than it really is. Since the credit crisis has mostly died down and the banks are in solid financial positions again, there is no need for the banks to manipulate the LIBOR rate. In fact, rates are nearly half of what they were in 2009, hovering right around 1% for the last 6 months. Also, since most of the lending rates for US firms are set based on the US Prime rate, not the LIBOR, the spillover effects should be negligible.
In the end, there may be a slight shift towards alternative lenders for the near term if a large number of CEOs get fired and cultures at banks become tentative. There may be political issues down the line as we try to use the law to control our banking and financial systems. In reality, this will only alter trust in the financial systems with little, if any, direct effects for business in the short run.