Understanding the Libor Scandal

Understanding the Libor Scandal

Introduction

Barclays bank agreed in late June to pay $453 million to U.S. and UK regulators(Reuters) to settle allegations that it had systematically manipulated the London Interbank Offered Rate, or Libor, between 2005 and 2009. It also fined Barclays for "misconduct" related to the European equivalent of the Libor, the Euro Interbank Offered Rate. The Libor scandal has already claimedthe jobs of high-profile bankers (Guardian) at Barclays, including CEO Robert Diamond, and the ongoing international investigation--of which the UK and U.S. settlements were a part--into the manipulation of interbank offered rates is expected to implicate other banks and their leaders in the weeks and months ahead.

What is the Libor?

The London Interbank Offered Rate--the Libor--is a benchmark interest rate based on the rates at which banks lend unsecured funds to each other on the London interbank market. The Libor is published daily by the British Bankers' Association (BBA). Each morning, global banks submit their borrowing costs to the Thomson Reuters data collection service. The calculation agent throws out the highest and lowest 25 percent of submissions and then averages the remaining rates to determine the Libor. Calculated for fifteen different maturities and ten different currencies, the Libor is considered the most critical global benchmark for short-term interest rates. Eighteen banks submit rates for the U.S. dollar Libor.

How does the Libor affect borrowing globally?

Many banks worldwide use Libor as a base rate for setting interest rates on consumer and corporate loans. When the Libor rises, rates and payments on loans often increase; they fall when the Libor goes down. The Libor is also used as a baserate on financial markets for a number of derivatives instruments, including futures contracts, options, and swaps. The Libor "is used for an increasing range of retail products such as mortgages and college loans," while also being used as "the basis for settlement of interest rate contracts on many of the world's major futures and options exchanges," explains the BBA. Some 45 percent of adjustable-rate prime mortgages and 80percent of adjustable-rate subprime mortgages are based on the Libor, while half of variable-rate private student loans are set to the Libor, according to the New York Times. Over $800 trillion in securities and loans are linked to the Libor, including auto and home loans (WSJ), says the U.S. Commodities Futures Trading Commission.

Why and how did traders at Barclays and other banks potentially manipulate the Libor?

Barclays and fifteen other global financial institutions (WSJ) are under international investigation by a handful of regulatory authorities--including those of the United States, the UK, Switzerland, Canada, and Japan--for allegedly manipulating the Libor rate between 2005 and 2009. Barclays, the only bank punished so far in the Libor scandal, reportedly manipulated Libor during the global economic upswing of 2005-2007 so that its traders could make profits onderivatives pegged to the base rate, explains CFR's Sebastian Mallaby. During that period, "swaps traders often asked the Barclays employees who submitted the rates to provide figures that would benefit the traders, instead of submitting the rates the bank would actually pay to borrow money," the Times notes. Moreover, explains the Times, "certain traders at Barclays coordinated with other banks to alter their rates as well." During this period, the Libor was maneuvered both upward and downward based "entirely on a trader's position," explains the London School of Economics' RonaldAnderson.

Following the onset of the global financial crisis, Mallaby says, Barclays manipulated the Libor downward by telling Libor calculators that it could borrow money at relatively inexpensive rates to make the bank appear less risky and insulate itself. The artificially low rates submitted by Barclays came during an "unprecedented period of disruption," says Anderson. It provided the bank with a "degree of stability in an unstable time," he argues.

What effect has the Libor scandal had on global financial markets, and what are potential repercussions?

"It distorts trust in the marketplace if you can't trust the rates at which banks are lending to one another," says Thomas Cooley of New York University's Stern School of Business. The Wall Street Journal's Franceso Guerrera notes that Libor manipulation meant "trillions of dollars of financialinstruments were priced at the wrong rate--a fact that could do wonders for plaintiffs' lawyers while undermining investors' confidence in financial markets." Indeed, securities broker and investment bank Keefe, Bruyette& Woods estimates that the banks being investigated for Libor manipulation could end up paying an approximate total of $35 billion in civil legal settlements, separate from any payments to regulators. "Relative to the size of the sixteen banks at risk of lawsuits in the Libor scandal, $35 billion is chump change. But it will be another blow to the banks' ability to hold enoughcapital to satisfy higher regulatory requirements in the wake of the financial crisis," notes the Huffington Post's Mark Gongloff.

What are some implications of the Libor scandal for bank regulatory policies?

The settlement between Barclays and the Commodity Futures Trading Commission (PDF)holds the "seeds" of a new regulatory regime, argues Guerrera. Barclay "must now base its submissions on market prices rather than some hazy estimate of borrowing costs," Guerrera writes. He adds, "If more settlements materialize, these rules likely will end up applying to other banks." Similarly, LSE's Anderson notes that the Libor-setting process is "by design not based on real transactions." Part of the solution, he argues, is to have the Libor set according to actual borrowing and lending done by banks, so that "the rate being quoted is based at that which people do business."

At the same time, leading central banks "dropped the ball badly," according to NYU's Cooley. The New York Federal Reserve, for example, knew Libor was "not reliable," he says, but it never followed up with the Bank of England after sending just one letter. Central banks have an obligation to "monitor the integrity of rates that function as Libor does," Cooley argues.

Anderson says the Libor scandal will likely spur regulatory intervention at the top levels of management at global banks and provide greater impetus for the adoption of international and national regulations. At the international level, "this episode is likely to stiffen the resolve of governments and regulators to press for not just adoption of the Basel recommendations, but their implementation and compliance," says Richard Reid, director of research at the International Center for Financial Regulation. In the UK, Reid says, the government faces pressure to implement the Vickers proposals, which call for putting ring fences around all UK-based retail and investment banking services. "There will be much more pressure now to demonstrate that there is a change of culture in the banks and, moreover, that this change is substantive and runs from top to bottom," he argues.

(Source: .cfr)