The LIBOR Scandal explained

In an article called “Explaining the Libor interest rate mess by CNN, Andrew Lo, MIT professor of finance referred to the LIBOR scandal as “dwarfing the magnitude of any other financial scam in the history of financial markets”.

The event can therefore intuitively and securely be connected to just about any field of contemporary economics or finance such as monetary and fiscal policy or international trade and investment.

The scandal relates to the manipulation of the London Interbank Offered Rate or LIBOR. This rate is an average rate calculated by the submissions of interest rates by all the major banks in London. The rate is overseen by the British Bankers’ Association (BBA) that estimates the rate to underpin approximately $350 trillion in derivatives. The LIBOR also influences everyday financial products such as student loans and mortgage loans that use LIBOR as a reference rate and so the scandal touched the pockets of millions of people.

The interest rates submitted by individual banks are those they are expecting to pay for borrowing from other banks or rates they are paying in reality. The LIBOR should thus indicate the overall health and stability of the financial system as it reflects an “average opinion” from all the individual banks involved. A bank confident in its operating environment would report a low rate and a bank in trouble would report a high rate. In June 2012, multiple criminal settlements by Barclays Bank revealed significant fraud and collusion by member banks connected to the rate submissions, leading to the scandal. Both the CEO of Barclays, at the time Bob Diamond, as well as the chairman Marcus Agius, resigned following this exposure of the scandal. Diamond claimed that he was unaware of any manipulation of LIBOR until his last month as CEO. However, many banks other than Barclays were also involved. An article by the Financial Times (July 27, 2012), featured a former trader admitting that manipulation of the LIBOR rate had been common since at least 1991. Another article by the New York Times Behind the Libor Scandal quoted a Barclays trader in New York communicating with his submitter on 13 September 2006: “Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the libor fixing at 5.39 for the next few days. It would really help. We do not want it to fix any higher than that. Tks a lot.”

Only recently (25 September 2012) had the BBA announced that it would accept the independent review recommendations of the Financial Services Authority and surrender oversight of LIBOR to UK regulators. To mitigate the possibility of a future scandal, the Financial Services Authority suggested the following changes:

  • Submitted rates should be based on actual rather than expected inter-bank deposits
  • Records should be kept of these transactions and submissions published after three months to promote inter-bank transparency
  • Criminal sanctions should be installed against the manipulation of benchmark interest rates

The UK government accepted all these recommendations and press for legislation implementing them.

What all this means for Tom, Dick and Harry is that financial institution customers may experience higher and more volatile borrowing and hedging costs after implementation of the recommended reforms. This is because banks were prone to understate their borrowing costs in the past rather than unduly inflate them. Such understatements were especially rampant during the financial crisis when banks attempted to appear stronger and less affected than they were. Another reason is the often vast exposures to the LIBOR rate that banks may have. For example: in an article “Does the LIBOR Reflect Banks’ Borrowing Costs?”, Citigroup reported that it would have made $936 million revenue in net interest if interest rates fell by a mere 0.25% during the first quarter of 2009 and $1935 million if interest rates fell by 1% instantaneously.

By Feakonomics4 (Peet Naudé)

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