What is the Libor scandal?

Posted Saturday, January 25, 2014 in Analysis

What is the Libor scandal?

The spike indicates a time when interest rates were historically low, but the Libor rate was abnormally high.

by Gina Hamilton

In recent days, there has been a lot of discussion of the so-called Libor scandal.  Libor is an acronym that stands for London interbank offered rate, and is an average interest rate calculated through submissions of interest rates by major banks in London. Libor underpins approximately $350 trillion in derivatives.

Banks lend money to one another all the time, based on customer behavior and for short term cash needs.  If the Libor average is higher than normal, a bank lending money to another bank stands to make a lot of money; if the average is lower than normal, it may not be considered a wise investment.  So with a manipulated rate, more money was being borrowed ... and in some cases, lost ... than would otherwise be happening.

Although the scandal is only recently been in the news, it had its origins in 2008, when the Wall Street Journal released a controversial study suggesting that some banks might have understated borrowing costs they reported for Libor during the 2008 credit crunch that may have misled others about the financial position of these banks. In 2011, the Journal reported that regulators were focusing on Bank of America, CitiGroup, and the Swiss investment bank UBS.

In February of 2012, it was revealed that the U.S. Department of Justice is conducting a criminal investigation into Libor abuse.    Among the abuses being investigated are the possibility that traders were in direct communication with bankers before the rates were set, thus allowing them an unprecedented amount of insider knowledge into global instruments. One trader's messages indicated that for each basis point (0.01%) that Libor was moved, those involved could net “about a couple of million dollars”.

the New York Federal Reserve released documents dating back to 2007 which showed that they were aware that banks were lying about their borrowing costs when setting Libor, and chose to take no action against them at that time. Then New York Fed president Tim Geithner, who is now Secretary of the Treasury, sent memos to Bank of England chief Mervyn King looking into ways to "fix" Libor. However, it appears that nothing was acted on at that time or for years later.  In one 2008 document a Barclays employee told a New York Fed analyst, "We know that we’re not posting um, an honest LIBOR, and yet we are doing it, because, um, if we didn’t do it, it draws, um, unwanted attention on ourselves."

In England, things began to happen in July of 2012, when several Barclays executives were forced to step down and the U.K.'s Serious Fraud Office began to investigate.  Shortly afterward, the U.S. Congress opened an inquiry, focusing on the communications between Geithner and Barclays and Bank of England.  Both Geithner and Bernanke were or will be questioned in already scheduled hearings.

US experts such as Former Assistant Secretary of the Treasury Paul Craig Roberts have argued that the Libor Scandal completes the picture of public and private financial institutions manipulating interest rates in order to prop up the prices of bonds and other fixed income instruments, and that “the motives of the Fed, Bank of England, US and UK banks are aligned, their policies mutually reinforcing and beneficial. The Libor fixing is another indication of this collusion."

Ben Bernanke, testifying Tuesday before the Senate Banking Committee, said that he still has little confidence in the Libor system. However, he also pointed out that it is not yet known whether any U.S. banks actually colluded in the rate-fixing scandal.  However, by now, Bank of America, Citigroup, and JP Morgan Chase have been mentioned, and more banks may also be implicated.

Barclays has paid $450 million in fines in the Libor scandal, but that is only the beginning of the costs to the banks involved.

The Libor scandal gets more expensive for the banking sector almost by the day.  Banks may end up paying $35 billion in civil penalties.  This may lead to some of the sixteen banks involved having trouble holding enough capital to satisfy higher regulatory requirements in the wake of the financial crisis.  And it is another nail in the anti-regulatory coffin.

The $35 billion would address only the lawsuits that will almost certainly be brought by a large number of institutional plaintiffs,  including cities and states that lost money in interest-rate swaps because of bank manipulation of Libor.

But regulators are likely to go after the banks, too, and those penalties will come much faster.

The ramifications of the scandal will be felt in the bond markets and in derivatives markets for years to come.  Institutional investors will be hit particularly hard by the manipulation.  And no one is really, truly sure if the rate fixing is even over.  Currently, rates are set by a small group of bankers in Britain.  Leaving them in charge is tantamount to leaving the fox guarding the henhouse, but there is currently no alternative to setting rates.

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