Editor’s note: This article, by Professor Philip Booth, editorial and program director at the Institute of Economic Affairs, the UK free-market think tank, examines some of the underlying issues that arise following the recent scandals concerning the LIBOR interbank interest rate system. While we understand that investigations are ongoing and more banks may be punished following the fines on Barclays, it is important at this stage to explore some of the issues beneath the headlines. The financial products sold to wealth management clients are, in part, linked to the LIBOR system. This publication should stress that while it does not necessarily endorse all the opinions expressed here, it is delighted to share these insights. Please do respond with your views.

Last week a major scandal came to light in the UK with regard to the setting of LIBOR, which is the interest rate at which banks lend to each other. It would appear that this rate, which is a useful index of short-term interest rates by which interest rates on other contracts (including mortgages) are set, was manipulated by traders in a particular financial institution. Presumably this was done for their own gain – at the expense of others who were counterparties to the contracts.

There have been the predictable calls for regulation. The French have said that this is a problem of rampant Anglo-Saxon capitalism which needs regulating – ignoring the fact that EURIBOR uses a more or less identical system. Mark Hoban – the relevant government minister – has said both that this is a moral problem and that LIBOR should be regulated. Others have said that the problem is that we have nationalized central banks setting interest rates. Still elsewhere, it has been suggested that the problem is that we have a banking cartel and we need more competition.

The latter two positions have been taken by respected free-market commentators, but I don’t think they are correct. Certainly, central banks distort LIBOR. They do this both because they determine very-short-term interest rates which feed into LIBOR indirectly and also because they try to smooth liquidity in the market. However, even if central banks did not do this, there would probably be a need for something like LIBOR as a base interest rate that is used to set interest rates on other financial transactions. In fact, LIBOR is a very useful market instrument because it means that banks can lend to and take deposits from customers at a rate which is always related to an objective and transparent market interest rate. Customers can be sure that they will not get taken for a ride. At the same time, the bank will know that it can always get funding for or make deposits at roughly that rate. Without LIBOR long-term, floating-rate mortgages would be that much more risky.

The bank cartel argument is also something of a red herring. Yes, it is true that the smaller the number of banks, the easier it is to manipulate the rate, but there are 16 banks on the sterling LIBOR panel, so the cartel argument is stretching things somewhat.

However, the main threat comes from those who only have the regulatory hammer and think that regulation is the only solution to any problem.

Older readers may remember the Maxwell scandal. This was a case of theft from a pension fund. Not surprisingly, theft of hundreds of millions of pounds is illegal. But, the UK government thought that, rather than making some simple changes to primary legislation to make theft less likely (for example, by having more independent trustees within pension funds), they would regulate defined-benefit pension schemes. Older readers might also remember private-sector, defined-benefit pension schemes. Younger readers cannot join them anymore because the regulation hammer (and some other factors) led to the vast majority closing down.

We must be careful with regard to the LIBOR scandal. The British Bankers Association (BBA) is, in a sense, a private regulator for LIBOR and the government seems to be using this as an excuse for castigating the private sector and bringing in government regulation. However, private regulation has an excellent history, and government regulation certainly has not proven itself superior in the financial sector.

We should resist arguments for more government regulation of LIBOR: neither government nor private regulation can bring about perfection. But we also need to point out any disingenuous statements from the proponents of government regulators given that the BBA states: "As all contributor banks are regulated, they are responsible to their [government] regulators, rather than BBA LIBOR Ltd or the FX&MM Committee, for maintaining appropriate procedures for contributing, including the maintenance of internal chinese walls."

But, surely, the main problem is not regulation in any case. Given Britain’s strict libel laws, I need to tread carefully. However, if what has happened is not fraud (and it is not being prosecuted as such at the moment) it ought to be. We do not need a specific government financial regulator to prosecute fraud and theft.

Secondly, as the minister has said, there is a moral and cultural issue here. Regulation is the wrong tool to deal with moral and cultural issues.

We have a confused regulatory system here. Instead of blaming private regulation we should perhaps go the whole hog and remove government regulation from the picture. LIBOR is a private arrangement and the banks that set it have the strongest incentives to keep it honest. The government should stick to prosecuting fraud. The private sector institutions that have an interest in LIBOR should club together and make sure that they impose the strongest possible penalties on those that disobey the letter or the spirit of the LIBOR regulations set by the BBA.

Something like ‘my word is my bond’ would be a good start and, if someone’s word proves not to be their bond then the sanctions – administered by the club itself – should be severe. Indeed, the market sanctions have been severe already. Barclays’ share price is down 15 per cent. We cannot expect perfection and to avoid all incidents within financial markets, but this seems like a good feedback mechanism to me.