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Libor rigging

Updated Monday 29th April 2013

What are Libor rates and why do they matter to us?

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In July 2012 Bob Diamond, the high profile American chief executive of Barclays, was ousted after the bank had been fined £290m by the FSA for its role in the Libor rigging scandal.

The Swiss bank UBS and the Royal Bank of Scotland (RBS) later followed Barclays into the Libor ‘hall of shame’ with fines of £940m and £390m respectively being imposed on them by the regulators for their roles in the manipulation of Libor rates. 

Before these developments, most people outside the financial services industry neither knew very much about Libor rates nor believed that they had any impact upon them.

Yet Libor rates directly or indirectly affect millions of households and businesses and the fact that these rates have been found to have been manipulated by bankers represents a scandal of enormous proportions.

So what are Libor rates and why do they matter to us?

Libor is an acronym and stands for London Interbank Offered Rate. Libors are the average rates at which the large banks transact borrowings in the international money markets for terms from overnight (i.e. a loan of one day) to 12 months.

Libors are set for a range of currencies – although the key ones are in US dollars, sterling and euros where transaction volumes are greatest. Note, though, that the European Banking Federation (the EBF) manages the compilation of an alternative equivalent to Euro Libor known as Euribor.

Libor rates were first established in 1986, principally to meet the City’s need for agreed money market rates to service the growing trade in financial markets products and derivatives which commonly incorporate Libor rates into their contracts.

The Libor determination process has, to date, been run by the British Bankers Association (the BBA) – the banks’ trade association. The process of setting these rates involves getting quotes on each banking day from a panel of banks.

The quotes are for the rates at which they could borrow funds, in a material size (say £10m or the equivalent in other currencies) for terms from overnight to 12 months. Once the quotes have been submitted the highest and lowest are disregarded and the Libor rates are then determined by the arithmetic average of the remaining quotes.

So if 16 banks submit quotes the top and bottom four are disregarded and Libor is an average of the quotes supplied by the remaining eight banks. This ‘topping and tailing’ is intended to ensure that the Libor rates could not be affected by the outliers amongst the submissions. 

The process for determining Libor rates seemed, on the face of it, to be proof against the capability of an errant bank from manipulating them. If you submitted a ‘false’ quote intended to benefit you then it would almost certainly be disregarded in the computation by being an outlier.

Yet even back in the 1990s those operating in the money markets – including myself – were commenting that, despite the methodology, Libor rates ‘stank’ a little bit. The finalised rates just did not seem quite to reflect the rates actually being paid by banks and other large financial institutions in the markets.

But with the methodology seemingly so manipulation-proof no formal challenge to the voracity of the Libor rates was mounted.

Now two decades on it appears that through the submission of false rates and collusion Libor rates were being manipulated for years to the intended advantage of at least certain of the banks on the Libor panels.

Given the scale of transactions to which Libor rates are applied even a slight manipulation of the rates – just a tiny fraction of one per cent - could materially benefit those banks submitting quotes.  

Additionally, during the height of the financial crisis in the late 2000s some banks may have submitted artificially low quotes in the Libor setting process - a practice known as ‘lowballing’. This was to prevent them from being seen to be quoting high rates for borrowing money in case observers viewed this as a sign that they had impaired creditworthiness.

The weakness of the Libor setting process has not been helped by the fact that the Libor rate setting process has not been subject to formal regulation. Additionally those dealers submitting the Libor quotes - who typically do not rank within the senior executive populations of banks - have not, perhaps, had their quotes subjected to robust internal checks.

Furthermore, although the wording of the question for the rates submitted by the bank panels has changed over the years most recently it has related to estimated rates rather than actual rates on real transactions. Clearly the rates paid on actual transactions for cash in the money markets are very auditable. Estimated rates for hypothetical transactions are not.

This still leaves the question of whether the Libor rigging scandal means anything to the public - after all it sounds like the stuff of chicanery in the complex international markets rather than an issue which impacts upon households and non-financial businesses.

This assumption is, however, wide of the mark. The influence of Libor rates is all pervasive. By setting the rates on trillions worth of transactions in pounds, dollars and other currencies Libor rates are critical in determining the rates at which the banks can borrow money and invest money.

This, in turn, helps determine the rates they pay on savings products and charge on loans and mortgages. Libor rates affect virtually all of us who have mortgage and savings products – albeit indirectly. Proof of this has been the preparedness of some mortgage lenders in the US to seek damages from the Libor rigging banks.

The upshot of the Libor rigging scandal was the 2012 Wheatley Review which, amongst many recommendations, concluded that in future the Libor setting process should be regulated and run by an independent body, and not the BBA. Implementation of these recommendations is now the responsibility of the new financial services regulators in the UK.

Libor rigging – another banking misdemeanour with wide ranging consequences. 

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