The Libor rate fraud and the fallouts

FE Team | Published: July 23, 2012 00:00:00 | Updated: February 01, 2018 00:00:00

Abdullah A Dewan
Many of us - mostly financial market watchers - couldn't escape from hearing about the recent interest rate manipulations by Barclays bank - a 300-year-old British bank. Barclays Chief Executive Bob Diamond has already resigned and the bank has agreed to pay $450 million dollars in fines for manipulating the London Interbank Offered Rate (Libor) - a benchmark interest rate on interbank borrowing. At least 15 global financial institutions are under investigation on three continents on allegations of syndicate behaviour in manipulating the Libor.
Barclays' $450 million fines are only the beginning of the costs to the banks involved in the Libor fraud. The scandal is getting more costly for the banking sector almost by the day as syndicate bank behaviour is unfolding. Banks may end up paying $35 billion in civil damages for manipulating Libor, according to a new report by analysts at Keefe, Bruyette & Woods (KBW) - an investment bank specialised in financial services.
KBW analyst Frederick Cannon estimated that to settle the civil lawsuit the three US banks - JP Morgan Chase, Bank of America, and Citigroup under investigations - may end up paying $4.8 billion, $4.2 billion and $3.1 billion respectively. These settlements exclude additional payments that will ensue from lawsuits by plaintiffs, including cities and states that lost money in interest-rate swaps because of Libor manipulations.
Libor was set up in January 1986 by the British Bankers' Association (BBA) to be used as the average interbank lending rate. It is also an international financial benchmark used to set interest rates for credit cards, student loans, and home mortgages. Estimate show that more than $800 trillion in securities and loans are linked to the Libor, including $350 trillion in swaps and $10 trillion in loans, including auto and home loans, according to the US Commodity Futures Trading Commission (CFTC).
The CFTC has also charged Barclays with fraud and a settlement was reached on June 27. In its charge sheet, the CFTC stated that Barclays traders ''coordinated with and aided and abetted traders at other banks when many derivatives contracts are settled or reset.'' The scandal is still unfolding and more banks are in the process of being implicated and charged.
How the LIBOR is set? A panel of six to 18 banks (including three US banks, JP Morgan Chase, Bank of America and Citigroup) report interest-rate estimates to the BBA - and the firm Thomson Reuters averages them to provide daily Libor rates. The highest and lowest 25 per cent of submissions are ignored; the average of the rest becomes the Libor rate. The participating banks provide the estimates on an honour system - one that is different from rates on observable transactions.
According to axcess.com, so far two general types of manipulations have been unearthed:
The first kind involved attempts to move Libor levels (up or down) to benefit a bank's own investment positions. The CFTC quoted e-mails exchanges between Barclays' traders and colleagues responsible for reports that would influence Libor. A typical appeal, according to CFTC reads, ''We have another big fixing tomorrow and with the market move I was hoping we could set Libor as high as possible.'' A sample response: ''Done ... for you big boy.''
The second kind happened during the 2007-2008 financial crisis. Banks appeared to have underreported Libor rates - giving an impression of being financially stable and strong. At the time banks were certainly nervous to lend to each other. The underreporting Libor rates were cooked up to help ease the aura of looming panic among the banks. According to Barclays employees, this was carried out with an ''everybody does it'' platitude - and perhaps with regulators' acquiescence.
For about two years now, there're ongoing investigations in the US, Europe and Asia - probing alleged mischiefs in the interest-rate-setting process. In 2008, Wall Street Journal published a series of articles - raising the spectre of global banks being involved in manipulating the process of setting a key interest rate by low-balling it to avoid looking desperate for cash amid the financial crisis
In his testimony before the British Parliament on July 09, Bank of England (BOE) Deputy Governor Paul Tucker denied encouraging Barclays executives to keep their Libor estimates low. He was specifically asked what he knew about the warning signs that the rate was being manipulated. The Federal Reserve Bank of New York recently released a 2008 memo from Timothy Geithner (then the President of the New York Fed) to BOE governor Mervyn King, calling for six changes he said would improve the credibility of Libor.
Meanwhile, US lawmakers are launching probes into attempts to manipulate Libor rates, widening the focus beyond the BOE to include regulators in the US who knew about the problem as early as 2007.
Analysts argue that a panel of banks contributing daily rate estimates toward constructing Libor, Barclays by itself could have only a small effect. They're wondering: How many other banks doctored the Libor rates, and by how much?
The extent of damage done by Libor manipulation is mixed. Some argue the manipulation doesn't matter much since nonconformities with market-determined interest rates weren't generally very large - and lower rates have benefited many consumers' interest payments on their debt obligations.
Others call it as they see it and rightly so - a flagrant racket which benefited banks in terms of boosted profits at the expense of customers and financial-market integrity. "For every homeowner who benefited from a fractional dip in mortgage rates, there may be an investor who was on the losing end of the manipulation (a pension fund, perhaps, or a factory that uses derivatives to hedge risks)." The US investment firm Charles Schwab is among those suing to collect financial damages from Libor rate setting panel banks.
Libor was set up to be market determined - reflecting broad financial market conditions. Unfortunately, "The organic self-correction of the market became a self-corruption of the market at the visible hand of Bob Diamond and other big bank officials. What is next? Well, every bad often brings the good. The scandal is likely to result in reforming Libor setting system or replacing it with benchmarks based on readily observable financial transactions as they occur. This seems to be the only logical course to pursue if the eroding public trusts in the banks are to be reverted.
The writer, formerly a Physicist and Nuclear Engineer, is a Senior Fellow at the Policy Research Institute, Dhaka and Professor of Economics at Eastern Michigan University, USA. adewan@emich.edu