A layman’s guide to the LIBOR scandal

LIBOR stands for London InterBank Offered Rate. It has become the global benchmark for market interest rates – these are related to but different from the official interest rates set by Central Banks at their policy meetings, eg Bank of England Base Rate.

Each day at 11am, a group of banks (a different group for each of 10 currencies, generally those who are considered most active in each currency) submit to the British Bankers Association (via Reuters) the rate of interest at which they believe they could borrow from other banks over 15 different maturities ranging from 1 day to 1 year. For each currency and maturity, the BBA exclude the top quartile and the bottom quartile and calculate the average of the middle two quartiles. This average is then published as the daily LIBOR fixing. Over time this has become the benchmark used for market interest rates (similar to the FTSE 100 Index used as the market benchmark for UK stocks), and has thus become the reference for nearly all derivative contracts relating to interest rates and many other loan contracts. Estimates as to the total value of contracts outstanding in LIBOR-related contracts vary since much of the trading is carried out as transactions directly between banks and not on market exchanges, but $300 trillion (12 zeroes in a trillion) is probably a conservative estimate – equivalent to more than $40,000 for every human being on the planet. A change of 1 basis point (0.01%) for 1 day on that nominal exposure results in $120 million of cash flow difference moving around the global financial system.

Arguably there are 3 scandals (so far).

  • From 2005 to 2007 when light-touch regulation was in vogue and banks proprietary trading desks were making enormous profits with consequent internal political power, it has become apparent that traders at Barclays and other banks sought to influence the rates that were contributed to the BBA by the rate contributors both at their own bank and in at least one case in other banks too. They were doing this to suit their own trading positions (by trying to get LIBOR to be marginally higher or lower so that they would make greater trading profits)
  • During the 2008 crisis, when lending between banks broke down and the entire financial system came close to collapse, there were no actual trades on which to base the numbers that the banks sent into the BBA. Further many banks did not wish to disclose the weakness of their positions to the wider world and so told their contributors to bias downwards their expectations of what interest rate they would have to pay in the market should they have been able to.
  • In 2007 the New York Federal Reserve were sufficiently concerned by what they felt was a weak process for such an important market price, that they wrote to the Bank of England about their worries. Mervyn King and Paul Tucker appear to have done very little in response to this warning, a fact that has already been picked up by the Treasury Select Committee.

Of these three scandals, the first is criminal if true and can be proved. However the method of calculation is designed to throw out entirely the very high and the very low inputs – it would require an enormous conspiracy between many banks to actually alter a LIBOR rate. The third is a political loss of face for the Bank of England and King and Tucker in particular – it will probably cost Tucker the chance of succeeding King as BoE Governor. The second is almost certainly true but equally contributed to keeping the whole financial system alive – the world was so chaotic at that time and no actual interbank trades were taking place that every LIBOR rate input was a judgement without any evidence to support it. It will be difficult to prove in a Court of Law that a knowingly wrong number was submitted. It is entirely possible that had banks contributed less optimistic judgements of their ability to borrow at the time, then the higher LIBOR rates this would have created could have made the crisis worse

Note that the 2005-2007 scandal involved only dollar and euro interest rates but not sterling rates, so no sterling borrower or lender will have been damaged by it. However this scandal reinforces the long-running narrative of politicians that banks have become forces of evil and must be increasingly heavily regulated. Sackings and resignations of the interest rate traders and many of their superiors right up to CEO level have and will continue to occur. A new system for calculating market interest rates is likely to be brought in in due course, one that will be based on actual transactions rather than best guesses. In the meantime compliance departments will be scrutinising very carefully every input to the BBA.

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