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The Trouble with Libor

The question: what exactly is Libor?  The standard answer: Libor is the London Interbank Offered Rate.  It is a measure of the various rates at which banks can borrow money from other banks.  And it’s important.  Libor is a globally cited benchmark for interest rates…things ranging from mortgages to student loans around the world are tied to Libor.

The real answer: Libor is whatever banks say it is…and that is why it is now at the center of a global scandal.  Two weeks ago, Barclays Capital (the second largest bank in the UK) was fined over $450 million by regulators in Britain and the US for manipulating Libor by reporting false borrowing costs from 2005 to 2009.

But the problem isn’t just Barclays.  It’s Libor.  The way the rates are calculated literally invites abuse of the system.

The calculation method is simplistic: since it was first published in 1986, every weekday (except for banking holidays) just after 11:00am London time, Thomas Reuters polls around 18 banks on the interest rate that they would need to pay to borrow money short-term (maturities from overnight to one year) in 10 different currencies.  Then two people (yes…just two people) in an office in London use a simple computer program to calculate the rates.  The computer throws out the highest and lowest 25% of the numbers, and averages the rest.  Around 11:30am the rates are published by the British Banking Association.  And there you have Libor.

In other words, banks can name their own borrowing rate, and then a little basic math is done. The whole method relies entirely on the truthfulness and cooperation of banks.  They are able to set one of the most important benchmark rates in the world by telling us what they believe their borrowing costs should be.  It’s an honor system, and it’s a stretch.

So why did Barclay’s lie?  From 2005 to 2007, Barclays fudged its Libor submissions for its own benefit…sometimes a trader would need Libor to be higher or lower than reality to make their bets pay off.  Then the tide started to shift in 2007.  The financial crisis took hold, and banks started to look at each other with a skeptical eye.  Barclays lowballed their Libor estimates, because if their borrowing costs looked to high, it would imply that the bank was unhealthy and at risk.

And they knew it was wrong.  As part of the settlement with regulators, emails from Barclays traders from the ‘scandal period’ were made public.  On December 4, 2007 a Barclays staffer responsible for Libor estimates admitted, “We are therefore being dishonest by definition and are at risk of damaging our reputation in the market and with the regulators”.  But not everyone at the bank took such a remorseful tone.  One trader told a rate submitter “Dude, I owe you big time!  Come over one day after work and I’m opening a bottle of Bollinger”.

But when someone pops the cork on a bottle of champagne in London, interest rates for borrowers around the world are impacted.  Libor rates are used as the benchmark for as much as $800 trillion in securities, loans and contracts globally.  Fiddling with a benchmark that has a global reach has real consequences for people.

And while Barclays has apologized, the bank was also quick to point the finger at just about anyone and everyone: “It (is) ironic that there has been such an intense focus on Barclays alone, caused by our being the first to settle in the midst of an industry-wide, global investigation”.  The bank insists that it was less guilty, and that other banks were far more manipulative of rates.  And in late 2008, it notified authorities of suspicious estimates from other banks.

Barclays is right.  This isn’t exclusive to one bank.  This is about the culture of the financial industry.  It’s a little hard to believe that Barclays manipulated Libor all by themselves.  And now several other banks are under investigation for their Libor submissions.

To put a positive spin on it, when banks lie and lower Libor, in effect they lower borrowing costs for consumers.  But that doesn’t mean we should look at this as a victimless deception, and the idea of tinkering with rates for their own benefit still damages whatever credibility they may have had left.

Libor is flawed.  When Wall Street and London’s financial district can tell us whatever they want us to hear, it’s not an honest reflection of the market.

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