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.

UK Economic Policy – Sticking to Plan A (plus a bit)

Last week as investors worried about the Greek elections, the Spanish bank bailout and the Federal Reserve meeting, George Osborne and Mervyn King made significant announcements about UK economic policy. Since coming to power, the UK’s approach to managing the economy can be described as a slow but steady tightening of fiscal policy over the medium term, to avoid an austerity-driven recession as seen in parts of Europe, combined with an extremely easy monetary policy.

The complicating factor to this logical response to the UK’s problems was capital requirements that had been placed on UK banks following the banking crisis – much more exacting prudential requirements with regard both to capital and to liquidity risks had forced the banks into buying large amounts of gilts (UK government bonds). Whilst one side of this coin meant that banks’ balance sheets were better protected, the other side of that coin is a reduced emphasis on the attractions of lending to small and medium sized businesses, which is a vital but nonetheless risky activity for banks.

Mr. Osborne announced a scheme to offer both government guarantees and cheap funding for banks that lend to the domestic personal and small business sectors – at £80bn this is approximately 5% of total existing lending to these sectors. Mr. King announced that going forward banks would not have to hold such large amounts of liquid gilts on their balance sheets, and thus would be able to make more loans (which are less-liquid assets) to business. There are few details yet but assessments of how much this might mean are around £150bn.

These announcements are clearly aimed at allowing the QE policy to work more effectively, which until now has worked to inject lots of money into the financial system. However, little of it has found its way into the real economy – thus financial asset prices (in particular the price of gilts) have been supported but with only a small impact on growth. The banks are receiving very strong guidance that they should be lending.

There remain though both demand and supply problems with this new approach, which are likely to mean that it will have only limited success. First, with regard to the demand for bank loans, the banks consistently report subdued demand to borrow. Certainly the housing market is slow (apart from Central London, which is beset with Greek, Russian and Middle Eastern investors seeking a safe home for part of their wealth) – falling house prices is not an incentive to borrow heavily and a lack of confidence in employment prospects or future pay increases is endemic. Similarly the subdued state of demand that many small businesses face will mean that very few are seeking to borrow to expand. Where there is demand to borrow from small businesses, it is usually to cover slow trading (or poorer credit risks). On the supply side, the credit boom conditions of 2002-2007 is now over and banks are not prepared to lend on the optimism-fuelled terms that were available then. Instead, they are reverting to lending terms similar to those on before 2002, which feel now much more restrictive to businesses.

Osborne and King are sticking with Plan A, but trying to make sure more liquidity gets into the real economy. It will help at the margin to boost private sector growth as the public sector continues to be cut back, but the general desire of most people and companies is to reduce their debt rather than increase it. This combined with the major uncertainties within the European economies, will prevent a rapid recovery. There are risks to gilt prices since the banks are being told that they do not need to own so many gilts, but the prospects for UK equity prices are positive given their very low valuations and the (minor) benefits to growth of this adjustment in policy.