Introduction1
Recently, Barclays Bank was fined a total of £290 million (USD 450 million) for attempting to manipulate the daily settings of London Interbank Offered Rate (Libor) and the Euro Interbank Offered Rate (Euribor) as a result of an international investigation.2
The controversy has left financial markets reeling and one may question the ethics of the banking industry.
Libor is the world's most widely used and most important benchmark for short-term interest rates because it is the rate at which the world's most preferred borrowers are able to borrow money.3
But what exactly is Libor, and why Barclays is in so much trouble for manipulating it?
Libor Concept
In simple terms, Libor is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is the primary benchmark, along with the Euribor, for short term interest rates around the world. 4
Every day, Banks need to work out how much money they need to borrow from other banks and how much they can lend.
Libor is therefore the cost of this inter-bank lending, setting out the average rate banks pay to borrow from one another.
Know, the question arises, who calculates Libor and how exactly is it calculated?
Libor Calculation
The British Bankers' Association (BBA), a private trade association, constructs LIBOR, and Thomson Reuters publishes it worldwide.
Libor calculation is done every day after taking into consideration the borrowing rates submitted by banks to BBA (British Banker's Association). Once these borrowing rates have been submitted by the bank, they are arranged in ascending order. The next step in calculation includes removing 50% of the rates (i.e. highest 25% & lowest 25% rates), average of the remaining rates will be LIBOR rate for the given day. For example if 16 banks provide their funding rates to BBA then, the highest 4 rates and lowest 4 rates will be excluded from calculation of LIBOR and the final rate for each day will be calculated by taking the average of remaining 8 rates .
The resulting rate is published at 11.30 am.5
It is calculated every business day in 10 currencies and 15 terms, ranging from overnight to one year.
What is the significance of Libor and what purpose does it serve?
Libor Significance
It is widely used as a reference rate for various financial instruments viz forward rate agreements, future contracts, interest rate swaps and floating rate notes.
Rates on about USD 10 trillion in corporate loans, mortgages and student loans worldwide are pegged to Libor. The total amount of financial contracts tied to Libor, particularly interest-rate swaps, exceeds USD 300 trillion, or USD 45,000 for every person in the world.
Hence, the rate has a worldwide impact since it is used as a reference rate around the world thereby effecting a large group of people, professionals, lenders and borrowers.
The Controversy
Barclays is accused of artificially lowering the borrowing cost submissions to mislead about their financial health and of manipulating the rate submissions to make profit from it.6
It has been reported that traders were in direct communication with the bankers before the rates were set, giving them insider knowledge into global instruments. It is further claimed that it was a common practice to make requests by the traders to banks to set the Libor rate as per their requests.7
Each movement of Libor of 0.01% (1 basis point Libor movement) would affect an amount to the tune of couple of million dollars.
Libor Manipulation
Now, Can a single bank manipulate Libor rate?
Because the highest and lowest survey responses are excluded, it may seem that a single bank on a LIBOR reporting panel cannot affect the final index.
However, a single bank can affect the index, but will not always be able to move the index in the direction it wants, or may not be able to move the index at all, under some circumstances.
It is possible for a single bank on the panel to affect the Libor rate if the bank's reported rates would have been within the middle of the responses, or if it can change which responses are the middle responses.8
What went wrong?
So what could be the reason which have lead to this manipulation and what are the lessons that can be learnt?
Libor, in theory, is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates.
But there are two major loopholes in the process of setting this number that leads to possibility of less than honest numbers.
First, it is based on the estimates given by the banks, rather than the actual prices at which banks have lent to or borrowed from one another.
A second problem is that those involved in reporting the rates stand to profit or lose money depending on the level at which Libor is set each day. This makes it an attractive incentive for the banks to report untruthful estimates.
The reputational impact of this controversy goes far beyond in impacting the trust in the banks. Trust in financial institutes is at an all-time low with little faith in the system and the people who run this system are often perceived as self serving self profiteering people. Need of the moment is to build a robust legal and regulatory framework by upgrading the vigilance levels on the banks activities.
We need to formulate risk management and internal control committee based on stronger ethics and accountability.
Conclusion
To conclude it can be said that the tone of the management at the top should be honest and the integrity of senior managers should be restored otherwise the reputational and financial cost of such unethical event would be massive and intractable. Independent auditing process would help plug the weak links in the accountability framework and prevent traders from exploiting them.
Footnotes
1 LLB intern
2 News article dated June 27 2012 on www.ft.com
4 Explanation from www.fas.org (Federation of American Scientists)
5 Explanation from www.fas.org (Federation of American Scientists)
6 Money.cnn.com
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