LIBOR scandal explained

Now that CEO’s heads are rolling and politicians are shouting, it may be a good time to explain what the Libor scandal is all about!

LIBOR (London Inter-Bank Offered Rate) rates are calculated daily for different currencies (USD, Euro, Yen, etc.) and maturities ranging from one day to one year. They are widely used as global benchmark for short term interest rates.

Supposedly, they should represent the prevailing interest rates at which banks lend to each other. A select number of “contributing” banks report daily their cost of borrowing money. The rates are set by 11:00am in London and published by the British Bankers Association (BBA).

There are hundreds of trillion dollars (approximately $360tn) worth of contracts worldwide benchmarked to Libor rates (loans among banks, derivative contracts, bonds, etc.). In 2007, some media outlets started claiming that the contributing banks were reporting “manipulated” levels of the rates to the BBA; in essence, the claims were that these institutions were reporting lower than “true” market levels in order to protect their trading positions and to be perceived as creditworthy. Nothing happened until recently. In June 2012, the US Department of Justice, the CFTC and the FSA found that Barclays indeed did try to manipulate Libor rates and fined the institution.

Why is the Libor scandal relevant?

a.) Virtually every bank in the world borrows and lends based on Libor rates.

b.) Millions of consumers and borrowers are affected daily by the levels of these rates. From Bloomberg Businessweek (“The Libor Scandal claims its first CEO”)

It is the benchmark for more than $360 trillion of securities, including mortgages, student loans, and swaps. “It’s an oligopolistic system dictated by a handful of players with implications for almost everyone in the world,” says Michael Livian, CEO of New York financial advisory Livian & Co. and a former banker in Europe for Bear Stearns.

c.) These rates are also a gauge of systemic risk in the financial system. Manipulated levels may mislead investors and regulators about true risks.

d.) Market failure. Free-markets are a great mechanism to allocate resources, promote economic growth and societal progress. However, markets function best when there are a multitude of participants and the perception of ethical foundations. Now, the risk is that the remaining “contributing” banks, concerned about their reputation, may withdraw from submitting their daily rates. This, in turn, may weaken the value of information of the market even further.

On a more positive note, this situation could finally represent the right opportunity to overhaul and reform the Libor market. We expect banks to face more scrutiny. Let us wait and see!

The scandal’s timing, says CLSA bank analyst Mike Mayo, is terrible for already unpopular financial institutions. In a July 2 note, he wrote: “We believe the industry is one more shoe to drop away from major regulatory aggressiveness against the banks given recent mishaps (JPMorgan’s trading loss), the presidential election, and a 40-year low for confidence in U.S. banks (last week’s new Gallup poll)

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