The Libor fuss!

The story behind the Libor scandal

Logos of 16 Banks Involved in Libor Scandal - YouTube

SINCE the outbreak of the Libor scandal, readers' reaction has ranged from the very basic: What's this Libor? to the more mundane: How does it affect me?

Some friends have raised more critical questions: Barclays appears to have manipulated Libor to lower it; isn't that good? The problem first arose in early 2008; why isn't it resolved by now? By popular demand to demystify this very everydayness at which banks fix this far-reaching key rate, today's column will be devoted to going behind the scandal starting from the very basics about the mechanics of fixing the rate, to what really happened (why Barclays paid the huge fines in settlement), to its impact and how to fix the problem.

What's Libor

The London Inter-Bank Offered Rate (Libor) was first conceived in the 1980s as a trusty yardstick to measure the cost (interest rate) of short-term funds which highly-rated banks borrow from one another. Each day at 11am in London, the setting process at the British Bankers' Association (BBA) gets moving, recording submissions by a select group of global banks (including three large US banks) estimates of the perceived rates they would pay to borrow unsecured in “reasonable market size” for various currencies and for different maturities.

Libor is then calculated using a “trimmed” average, excluding the highest and lowest 25% of the submissions. Within minutes, the benchmark rates flash on to thousands and thousands of traders' screens around the world, and ripple onto the prices of loans, derivatives contracts and other financial instruments worth many, many times the global GDP. Indeed, it has been estimated that the Libor-based financial market is worth US$800 trillion, affecting the prices that you and me and corporations around the world pay for loans or receive for their savings.

A file photo showing a pedestrian passing a Barclays bank branch in London. Barclays has been fined £290mil (US$450mil) by UK and US regulators for manipulating Libor. — EPA

Indeed, anyone with a credit card, mortgage or car loan, or fixed deposit should care about their rate being manipulated by the banks that set them. In the end, it is used as a benchmark to determine payments on the global flow of financial instruments. Unfortunately, it turns out to have been flawed, bearing in mind Libor is not an interest rate controlled or even regulated directly by the central bank. It is an average set by BBA, a private trade body.

In practice, for working purposes, Libor rates are set essentially for 10 currencies and for 15 maturities. The most important of these relates to the 3-month US dollar, i.e. what a bank would pay to borrow US dollar for 3 months from other banks. It is set by a panel of 18 banks with the top 4 and bottom 4 estimates being discarded. Libor is the simple average (arithmetic mean) of what is left. All submissions are disclosed, along with the day's Libor fix. Its European counterpart, Euro Interbank Offered Rate (Euribor), is similarly fixed in Brussels. However, Euribor banks are not asked (as in Libor) to provide estimates of what they think they could have to pay to borrow; merely estimates of what the borrowing rate between two “prime” banks should be. In practice, “prime” now refers to German banks. This simply means there is in the market a disconnect between the actual borrowing costs by banks across Europe and the benchmark. Today, Euribor is less than 1%, but Italian banks (say) have to pay 350-40 basis points above it. Around the world, there would similarly be Tibor (Tokyo Inter-Bank Offered Rate); Sibor and its related SOR (Swap-Offered Rate) in Singapore; Klibor in Kuala Lumpur; etc.

What's wrong with Libor?

Theoretically, if banks played by the rules, Libor will reflect what it's supposed to a reliable yardstick to measure what it cost banks to borrow from one another. The flaw is that, in practice, the system can be rigged. First, it is based on estimates, not actual prices at which banks have lent to or borrowed from one another. They are not transactions based, an omission that widens the scope for manipulation. Second, the bank's estimate is supposed to be ring-fenced from other parts of the bank. But unfortunately walls have “holes” often incentivised by vested-interest in profit making by the interest-rate derivatives trading arm of the business. The total market in such derivatives has been estimated at US$554 trillion in 2011. So, even small changes can imply big profits. Indeed, it has been reported that each basis point (0.01%) movement in Libor could reap a net profit of “a couple of million US dollar.”

The lack of transparency in the Libor setting mechanism has tended to exacerbate this urge to cheat. Since the scandal, damning evidence has emerged from probes by regulators in the UK and US, including whistle blowing by employees in a number of banks covering a past period of at least five years. More are likely to emerge from investigations in other nations, including Canada, Japan, EU and Switzerland. The probes cover some of the largest banks, including reportedly Citigroup, JP Morgan Chase, UBS, HSBC and Deutsche Bank.

Why Barclays?

Based on what was since disclosed, the Libor scandal has set the stage for lawsuits and demands for more effective regulation the world over. It has led to renewed banker bashing and dented the reputation of the city of London. Barclays, a 300-year old British bank, is in the spotlight simply because it is the first bank to co-operate fully with regulators. It's just the beginning a matter of time before others will be put on the dock. The disclosures and evidence appear damaging. They reveal unacceptable behaviour at Barclays. Two sorts of motivation are discernible.

First, there is manipulation of Libor to trap higher profits in trading. Its traders very brazenly pushed its own money market dealers to manipulate their submissions for fixing Libor, including colluding with counter-parties at other banks. Evidence point to cartel-like association with others to fiddle Libor, with the view to profiteering (or reduce losses) on their derivative exposures. The upshot is that the bank profited from this bad behaviour. Even Bob Diamond, the outgoing Barclays CEO, admitted this doctoring of Libor in favour of the bank's trading positions was “reprehensible.”

Second, there is the rigging of Libor by submitting “lowered” rates at the onset of the credit crunch in 2007 when the authorities were perceived to be keen to bolster confidence in banks (to avoid bailouts) and keep credit flowing; while “higher” (but more realistic) rates submission would be regarded as a sign of its own financial weakness. It would appear in this context as some have argued that a “public good” of sorts was involved. In times of systemic banking crisis, regulators do have a clear motive for wanting a lower Libor. The rationale behind this approach was categorically invalidated by the Bank of England. Like it or not, Barclays has since been fined £290mil (US$450mil) by UK and US regulators for manipulating Libor (£60mil fine by the UK Financial Services Authority is the highest ever imposed even after a 30% discount because it co-operated).

Efforts at reform

Be that as it may, Libor is something of an anachronism, a throwback to a time long past when trust was more important than contract. Concern over Libor goes way back to the early 2008 when reform of the way it is determined was first mooted. BBA's system is akin to an auction. After all, auctions are commonly used to find prices where none exist. It has many variants: from the “English” auction used to sell rare paintings to the on-line auction (as in e-Bay). In the end, every action aims to elicit committed price data from bidders.

As I see it, a more credible Libor fixing system would need four key changes: (i) use of actual lending rates; (ii) outlaw (penalise) false bidding bidders need to be committed to their price; (iii) encourage non-banks also to join in the process to avoid collusion and cartelisation; and (iv) intrusively monitor the process by an outside regulator to ensure tougher oversight.

However, there are many practical challenges to the realisation of a new and improved Libor. Millions of contracts that are Libor-linked may have to be rewritten. This will be difficult and a herculean exercise in the face of lawsuits and ongoing investigations. Critical to well-intentioned reform is the will to change. But with lawsuits and prosecutions gathering pace, the BBA and banking fraternity have little choice but to rework Libor now. As I understand it, because gathering real data can often pose real problems especially at times of financial stress, the most likely solution could be a hybrid. Here, banks would continue to submit estimated cost, but would be required to back them with as many actuals as feasible. To be transparent, they might need to be audited ex-post. Such blending could offer a practical way out.

Like it or not, the global banking industry possibly faces what the Economist has since dubbed as its “tobacco moment,” referring to litigation and settlement that cost the US tobacco industry more than US$200bil in 1988. Sure, actions representing a wide-range of plaintiffs have been launched. But, the legal machinery will grind slowly. Among the claimants are savers in bonds and other instruments linked to Libor (or its equivalent), especially those dealing directly with banks involved in setting the rate. The legal process will prove complicated, where proof of “harm” can get very involved. For the banks face asymmetric risk because they act most of the time as intermediaries those who have “lost” will sue, but banks will be unable to claim from others who “gained.” Much also depends on whether the regulator “press” them to pay compensation; or in the event legal settlements get so large as to require new bailouts (for those too big to fail), to protect them. What a mess.

What, then, are we to do?

Eighty years ago banker JP Morgan jr was reported to have remarked in the midst of the Great Depression: “Since we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgement and not of principle.” Indeed, bankers have since gone overboard and made some serious mistakes, from crimes against time honoured principles to downright fraud. Manipulating Libor is unacceptable. So much so bankers have since lost the public trust. It's about time to rebuild a robust but gentlemanly culture, based on the very best time-tested traditions of banking. They need to start right now.

WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: starbizweek@thestar.com.my.

After Barclays, the golden age of finance is dead

Retribution and regulation are sure to follow the Barclays scandal, but if the City is shackled, Britain as a whole will suffer

Everyone's a loser: punishing the City is inevitable following the Barclays scandal, but the whole of Britain could suffer Photo:

Just when you thought bankers could sink no lower in public regard, they’ve done it. News that Barclays has been found guilty of repeatedly falsifying the interbank rate – sometimes for the personal gain of traders, sometimes to make the bank itself seem more creditworthy than it really was – tops off another calamitous week in the seemingly never-ending litany of banking misdemeanours.

Coming hard on the heels of the chaos surrounding an IT breakdown at Royal Bank of Scotland, it is as if bankers are actively out to confirm their reputation for recklessness, incompetence and self-enriching disregard for the interests of customers and the wider economy.

At a time when the political and regulatory backlash against finance is already at fever pitch, much of it ill-thought out, counterproductive and economically harmful, there could scarcely have been a more spectacular own goal. And it doesn’t end there. Banking faces a whole new raft of separate regulatory strictures over the mis-selling of interest rate swaps to business customers.

A year ago, Bob Diamond, chief executive of Barclays, told a committee of MPs that it was time to put the crisis behind us, move on and stop apologising for the failings of the past. He should be so lucky. Not since the Thirties has finance been so much in the dock. On and on the combination of retribution and regulatory crackdown will go until banking is once again thought sufficiently imprisoned to be safe. European policymakers will delight in the ammunition they have been given to rein in the Anglo-Saxon bankers and make them subject to the rule of Brussels and Frankfurt.

Many have already said it, but it is one of those observations that bears constant repetition: in all my years as a financial journalist, it’s hard to recall a case quite as shameful as this – and I’ve certainly seen a few.

There is no industry in all commerce that relies as much on public trust and reputation for probity as banking. We have seen what happens when trust is lost: we get the legion of banking runs that lie at the heart of the financial crisis; people run for the hills and the economy grinds to a halt.

To have American regulators accuse Barclays of lies, deception and manipulation is an appalling indictment of one of the oldest and most respected names in British banking. It is like discovering that your local branch manager has routinely raided your hard-earned savings to finance his champagne lifestyle.

Entrusted with the public’s money, bankers have to be seen as whiter than white, pillars of their community and morally beyond reproach. All these old-fashioned virtues seem to have been lost in pursuit of the easy rewards of international finance. “My word is my bond” – once one of the sacred principles of City finance – has become reduced to a laughable parody of itself.

Now, it may well be unfair to single out Barclays. We already know that at least 20 other banks are under investigation for alleged manipulation of interbank interest rates, including most of the other UK high street banks. It could be that others are equally at fault. We know about Barclays only because in a practice that City lawyers sometimes call “rowing for the shore”, it has decided to abandon the flotilla of co-defendants and settle with regulators.

Downside of plea bargain

In so doing, it may have succeeded in winning both a lower fine and immunity from criminal prosecution, as a corporate entity at least, though the individuals involved may not escape. The downside of such plea bargains is that they involve admission of guilt. The regulator gets free rein to be as critical as it likes, while the mitigation of any defence there might have been is lost.

That these practices appear to have been endemic, not just at Barclays, but across a wide range of international banks, neither excuses nor explains what happened.

It’s interesting that when the fines were first announced on Wednesday, there was barely a flicker of recognition in the Barclays share price. The investigation has been known about for some time, the misdeeds complained of date back three or more years and are therefore water under the bridge, and many in the City judged Barclays to have got off relatively lightly.

But as the night wore on, the seriousness of the situation began to sink in. Bob Diamond, the Barclays chief executive, long despised by regulators found himself politically friendless, too.

As calls for his head mounted, the share price began to plunge. The key concern about Barclays has always been that it is a “black box” operation that only Bob himself properly understands. At a time of growing financial chaos, Barclays could be left leaderless, with the investment banking brains behind much of its recent profitability and successful navigation of the banking crisis thrown to the wolves.

“Bob is mistrusted in the City,” says one seasoned fund manager, “but he’s the glue that holds the whole thing together. Without him it might well disintegrate.”

What went wrong?
 
So what really went wrong here? The London Interbank Offered Rate, or Libor, and its companion, Euribor, are two of the most important benchmarks in finance. Essentially, they are an aggregate of the rates at which banks lend to one another. They are also used to help price a vast array of lending decisions and derivative products, including mortgages.

Yet even in financial markets, it is not widely understood how these benchmarks are arrived at. Unbeknown to senior managers at Barclays, some traders, starting in around 2005 and stretching through to 2009, began persuading those responsible for compiling Barclays’ input to distort the rate in a manner that made their own derivative positions more profitable, hence the excruciating series of incriminating emails cited by regulators.

This was bad enough, but if it had stopped there, the damage would probably have been containable. Even the best of internal controls cannot prevent the determined rotten apple. What has transformed this case into something much more serious is that at the height of the banking crisis “senior managers” themselves – it is still not clear exactly who – ordered that the Barclays submission be manipulated so as to make it look as if the bank was receiving more favourable funding terms than it was. Deceitful behaviour seemed to have become endemic, stretching from top to bottom.

To the extent that there is a defence for such blatant deceits, it runs something like this; everyone else was doing the same thing. Rival banks that were plainly in even worse shape than Barclays were making Libor submissions that appeared to show they were enjoying more favourable wholesale funding rates than Barclays was. On the “if you cannot beat them” principle, Barclays determined to join them.

If this version of events is correct, the whole escapade doesn’t look as bad as it first appears. It is hard to identify who exactly lost out as a result of these fictions. Since there was no interbank funding to speak of at the height of the crisis, it may not in any case have mattered very much.

Even so, it’s quite damning enough. There appears to be nothing bankers will stop at in order to feather their own nests. With tempers already at boiling point over egregious levels of pay and aggressive tax avoidance, the whole affair has now taken on a life of its own.

When the history books are written, this may be seen as a defining moment, the point at which public anger with the banks bubbled over into something much more seismic in its consequences than the general atmosphere of bank bashing we have seen to date. Despite the crisis, there has been a sense of back to business as normal for the City these past three years.

There have been few signs of behavioural change. But this may be the straw that breaks the camel’s back.

Market and regulatory pressures are already laying waste to great tracts of previously highly lucrative banking activity. A major cull of investment banking jobs is expected over the next year, with once bumper bonuses and earnings much reduced on top. Retribution and punishingly restrictive levels of regulation won’t be far behind.

Those who believe that Britain has become too dependent on finance for its own good will no doubt welcome this humbling of an apparently out-of-control City, but they should be careful what they wish for.

Finance’s golden age may be drawing to a close; with no new industry or manufacturing renaissance coming up in the wings, it is not entirely clear what’s going to take its place as a source of British wealth, jobs and tax revenues. It is not just finance for which hard times lie ahead. - Telegraph

By Jeremy Warner

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