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LIBOR: a primer to understand the scandal better

Published 7 years ago by BlackDigits

Published on the MONEY magazine - September 2012 issue

LIBOR stands for the London InterBank Offered Rate and it is an indication of the rate at which a leading bank can obtain unsecured funding in the London interbank market. Even though only banks are able to borrow at this rate, the LIBOR is written in standard derivative contracts and a range of retail products issued by banks worldwide are indexed to this rate. It was reported that the current value of products linked to LIBOR is between $360 and $540 Trillion. 

The LIBOR is calculated by the financial news company Thomson Reuters for the British Bankers’ Association (BBA) on daily submissions from banks that are members of the BBA. Submissions are made for a “marketable size” (which is broadly defined) in 10 currencies with 15 maturities - ranging from overnight to 12 months - thus producing 150 rates for each business day.

The BBA appreciates that not all member banks will require funding in each of the currencies and maturities quoted everyday and so the rates submitted should be based on an estimate calculated in terms of the bank’s models. The highest and lowest submissions are thrown out, the remainder  are averaged and voila, the LIBOR! The LIBOR is not only a rate determined by different models set independently by each member bank but it is also generated by a trade group and not a regulatory agency.

Really and truly, the LIBOR is a theoretical rate because the rate is not determined in an open market. Indeed Sir Mervyn King, the Governor of the Bank of England, in November 2008 described the LIBOR as "It is in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content. I think it is convenient, very often, for people to justify what they do for other reasons, in terms of Libor, but it is not a rate at which anyone is actually borrowing.” Sir Mervyn King also mentioned that hardly any bank lends unsecured after the financial crises. Now banks deposit their overnight funds with the Central Bank. 
Ironically, even when the LIBOR was not manipulated, it probably did not bear relation to reality because unsecured lending dried up in 2008.

The rigging – how did it work? 

Several derivative contracts derive their value from the LIBOR and for this reason traders are not involved in the LIBOR submission since they  would have an incentive to submit a rate in favour of their positions. However traders still managed to influence the LIBOR setters. This was bound to happen because the system is rotten – the setters also had an incentive to misrepresent their submissions since their own bank stood to profit by submitting the “right” LIBOR. E-mails quoted by government regulators showed a message sent by a Barclays trader to a rate setter saying “When I retire and write a book about this business your name will be written in golden letters.”

The LIBOR is determined by submissions made by several member banks and one bank alone is unlikely to manipulate the rate. Indeed it appears that groups of derivative traders working in several member banks colluded to manipulate the rates. The infamous quote mentioning the opening of a bottle of Bollinger was allegedly sent from another bank’s trader to a Barclays trader. At the time of writing 20 member banks have been named in various LIBOR investigations. 

There is a second aspect to the LIBOR manipulation. The LIBOR is the benchmark of the overall health of the banking system since low rates mean banks trust the economic climate will not pull down their counterparties and are therefore willing to lend unsecured. 

In this respect Bob Diamond, Barclay’s CEO until recently, claimed that he received a number of calls from senior UK Government officials in the midst of the financial crisis enquiring why “Barclays was always toward the top end of the LIBOR pricing”. The rate probably was higher than “usual” because at the time Barclays was widely viewed as the next UK bank to need a government bailout rather than any irregularity in the LIBOR submissions. Mr Diamond however interpreted these calls as encouragment to lowball Barlcay’s LIBOR submissions in order to project a healthier position. This allegation was vividly denied by Paul Tucker, the Bank of England’s Deputy Governor but ties to a study published by the Wall Street Journal in 2008 suggesting that banks might have understated their LIBOR submissions in order to improve the perceived financial health of the banking system.
The lessons of the LIBOR scandal is that we have not learnt the lesson. Self-regulation does not work. Regulators need to understand that the culture of today on Wall Street is far away from clubby values of yore. Banks will try to abide with every letter of the law just because they want to exploit all the loopholes available.

To add insult to the injury most of the banks that allegedly colluded in the LIBOR submissions received bailout funds and at the same time did not lose too much sleep on the higher rates the same taxpayers were paying on their mortgage.

The consequences 

LIBOR fixing has already cost Barclays $450 million however this is just be the beginning. A number of other banks are currently under investigation by their respective regulators. Lawsuits have also been filed against BBA member banks claiming they lost money as a result of the manipulation. In addition, the collusion of LIBOR submissions effectively constitutes a cartel in terms of EU law and it is likely that the EU Commission will not look kindly into this case. EU Commission investigations on cartels take several years to complete and can result in fines of up to 10% of turnover. 

As The Economist put it, this is the banking industry’s tobacco moment. 

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