The LIBOR-fixing scandal that has engulfed Barclays and prompted investigation of Citigroup, Royal Bank of Scotland, HSBC, UBS, Lloyds, Deutsche Bank, ICAP (the huge broker for traders) and possibly others has been down-played by some experts and induced outrage from others. More fines like the $453 million extracted from Barclays will undoubtedly be announced. And perhaps more resignations such as those of Barclay’s CEO and COO last week are in the offing. But the financial press is struggling to find the broader implications.
LIBOR (the London Inter-bank Offered Rate) is massively important. When banks extend credit, the price they charge is constructed on a cost-plus basis. LIBOR is the predominant referenced cost. It represents the cost of securing the cash to loan. Thus, a loan might bear interest at “LIBOR plus 1%,” the 1% representing the profit margin needed to compensate the bank for taking on credit risk.
LIBOR is an index, like the Dow Jones Industrial Average. Unlike the DJIA, it is not calculated by referring to quoted market prices, however. It is constructed using a remarkably quaint and inexact process. The concept has been around for 50 years, but was formalized in the mid-1980’s by the British Bankers Association, a trade group that also lobbies on behalf of UK banks. Ironically, the Chairman of the BBA was also the Chairman of Barclay’s until recently. The BBA contracts out to Thomson Reuters who polls the largest banks each day, asking a simple question:
At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?
The question is so imprecise that it begs for gamesmanship.
This question is asked for 150 or so categories representing different maturities and currencies. Different combinations of banks are polled for each category, the largest being the U.S. dollar 3-month LIBOR rate for which 18 banks are polled. Thomson Reuters eliminates the highest and lowest responses and averages the remainder.
The press has used a variety of estimates of the impact of LIBOR, ranging as high as $500 (the Bank of England estimate) to $800 trillion in loans, securities and derivatives that are linked to the LIBOR index. These estimates may well be vastly understated because they appear to exclude the huge currency markets ($3-4 trillion per day turnover). Relative values of currencies are a direct mathematical function of differing borrowing rates in the currencies being valued. For example, the difference in value between U.S. dollars and euros is largely a function of the difference between U.S. dollar LIBOR and euro LIBOR. While not overtly indexed to LIBOR, the effect is the same.
Whatever calculations are used, the numbers are simply staggering.
The regulators that fined Barclays identified two different games run by the bank. Starting in 2005 (though probably much earlier), there is evidence that the individuals who reported their borrowing rates to Thomson Reuters worked with traders of securities and derivatives linked to LIBOR. Their purpose was to influence LIBOR rates for short-term trading profits. Of course, Barclays was only one bank whose influence over the result was limited. However, if a trader held a $100 billion position, one hundredth of one percent difference in the LIBOR rate represented a tidy profit for a day. Routinely knowing this ahead of time was a represented a huge opportunity.
Of course, if banks colluded the effects could be much larger. There is little doubt that the regulators are combing through e-mails as we speak, searching for evidence.
The second “game” was specific to the darkest days of the financial crisis. Each bank’s reported borrowing rate is disclosed in the Thomson Reuters process. A bank’s borrowing rate is an indication of its creditworthiness. It is reported that Barclays intentionally low-balled its borrowing rate to create the illusion that it remained sound. This would potentially deceive lenders to the bank as well as bank regulators and investors in the bank’s shares. Of course, borrowers linked to LIBOR experienced lower interest rates, but the health of a Too-Big-To-Fail bank was obscured at a time when accurate information was absolutely critical.
Several commentators have said that the whole episode is relatively unimportant since the effects of mis-reporting were diluted by the polling procedure and would be corrected by the market arbitrageurs who would efficiently squeeze out anomalies. This is nonsense, given the scope of LIBOR indexed loans, securities and derivatives and probably is sourced from self-serving spin by the financial services industry.
But even more important are the implications of the LIBOR gaming to the regulations governing the financial markets currently being implemented. This episode is a stark reminder that financial institutions are influenced by incentives that are so strong that they simply cannot be trusted. As a Bloomberg reporter observed, “If Barclays would lie about its borrowing cost, what else would it lie about?” Rules must be crafted with this in mind. The financial services industry is lobbying hard for a system that establishes broad standards but allows banks great discretion to self-administer compliance. This approach will not work. The LIBOR scandal and the recently disclosed failure by JP Morgan Chase to control its London Chief Investment Office are stark reminders that this is so.