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Off-Grid Financing

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The ramifications of the Libor scandal—what Warren Buffett glibly called a can of worms that affects the whole world—grow by the day. Criminal indictments of individuals, even if firms are too big to indict, appear to be in the making as the tsunami’s shock waves are about to spread to many of the usual suspects. One can only imagine the trial lawyers licking their chops. Has there ever been a class action lawsuit on behalf of the whole world?

Central bankers and regulators, understandably panicked at the height of the crisis, may have been complicit in some of the distortions in an effort to create the pretense of financial system stability. However, like the so-called “war on terror,” we find the war on financial system collapse is filled with ends-justifying-the-means moral and legal questions.

Regardless of the specific consequences to individuals, firms, and even institutions, the systemic implications of this “can of worms” are stunning. In our relentless push towards efficiency, Libor has become the central grid of the global financial system, directly or indirectly linking the vast majority of savers and borrowers across markets and national boundaries. It also links risk transfer via the multi-hundred-trillion-dollar global derivatives markets. And don’t believe the experts when they say this is “only” a short-term interest rate. Three-month Libor is the foundation of the term structure of interest rates—a change in Libor changes the forward rates by simple arithmetic. For example, the one-year interest rate is a function of the three-month rate, and the nine-month forward rate beginning in three months. The two-year rate is similarly a function of the one-year rate, and on and on. When you manipulate Libor, you manipulate everything.

If a terrorist wanted to undermine the highly interconnected global capital markets, there would be no better tactic than to plant an impossible-to-resolve fraud in the heart of Libor. The consequences are impossible to predict with any confidence. Like all systemic failures, we are left facing not risks that can be managed, but with uncertainty.

Why did we design a system (or allow it to evolve organically) so vulnerable to such a terrorist attack? Because we are infatuated with the efficiency benefits, and we undervalue system resiliency. And what’s the knee-jerk regulatory response? More regulatory oversight needed.

Financial misconduct followed by calls for more regulatory oversight is an all too familiar pattern. What’s needed is profound structural change in the architecture of our financial system, not simply more regulatory oversight. To quote sustainable design expert and author of Cradle to Cradle: Remaking the Way We Make Things Bill McDonough, “From a design perspective, a regulation is a sign of design failure.”

Don Shaffer, President of RSF Social Finance, recently used the term “off-grid finance” to describe their work reconnecting small business borrowers and lenders in relationship with each other. He explained how RSF convenes borrowers and lenders to discuss, among other issues, what the appropriate interest rate should be for the coming year, based on an understanding of the other’s perspective only possible when the creditor/borrower contract is rooted in direct relationship. They rejected Libor before it was disclosed to be a fraud, and created their own base rate. My reaction when I heard this (prior to the Libor scandal) was one of fond respect for the intention with a touch of amusement. It’s a nice idea, but how inefficient!

Well, now with our confidence in the Libor “grid” itself undermined and a lawsuit honeypot, the resiliency of such a relationship-driven, off-grid credit system and of numerous other off-grid finance initiatives such as community capital, crowd sourcing, peer-to-peer lending, and even complementary currencies are shining brighter, despite the associated challenges and comparative inefficiencies.

—John Fullerton

John Fullerton is the founder and president of the Capital Institute. He is also the principal of Level 3 Capital Advisors, LLC, an investment firm focused on high impact sustainable private investments. This article originally appeared on his blog, The Future of Finance.

As an impartial, nonprofit forum for the finance and banking industries NYSSA encourages discussion and debate among its member and other professionals. Commentaries, however, should be taken as the sole opinion of the author(s) and not of NYSSA. If you would like to submit a commentary to the Finance Professional's Post, send your article to the editor.

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