LIBOR: The Biggest Financial Scandal Ever?

Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article recently appeared in the Korea Times.

Barclays, a 300-year-old British Bank, just paid a $453 million fine for manipulating LIBOR. Why the big fine? LIBOR (the London Interbank Offered Rate) is the most important short-term interest rate benchmark in the world. More than $10 trillion of securities and $350 trillion of derivative contracts are tied to LIBOR. Do the math and it is easy to see what impact a 1-basis-point change (one hundredth of one percent) could have with trillions of dollars involved.

The problem is that LIBOR is not a market-based rate but one set daily by survey. Each morning at 11:00 a.m. London time, 18 banks are asked the rate at which they could borrow from other banks in 15 maturities, from one day to one year, and in 10 currencies. Thomson Reuters aggregates the rates by rejecting the four highest and lowest and calculates the average LIBOR from the remaining 10 rates. This process is repeated 150 times for the 15 maturities and 10 currencies. Once calculated, the LIBOR figures are published and disseminated throughout the world. The most important of the 150 rates is the three-month dollar LIBOR.

LIBOR acts as a benchmark or reference rate for trillions of dollars of financial securities such as credit cards, corporate loans, home mortgages and just about any security that has a floating interest rate, as well as derivative contracts such as interest rate and currency swaps are tied to LIBOR. The impact of changes in LIBOR to borrowers and lenders is significant. For comparison, a one basis point (.0001) change on one $1 trillion of securities is $100,000,000. Given the $300 trillion to $400 trillion conservative estimate of securities and derivative contracts that are tied to LIBOR (some estimates are as high as $600 trillion), the amounts involved are huge.

Barclays had manipulated its LIBOR figure hundreds of times from 2005 to early 2009. Some were at the urging of its traders to help positions they had in derivative contracts and other securities. Also, during the financial crisis of 2008-2009, the bank purposely lowered its LIBOR bid because a higher rate at which banks could borrow would signal higher default risk. The banks that were too big to fail were under severe pressure at the time and any sign of weakness would have prompted massive withdrawals and/or a call for more collateral as counterparty risk was perceived to have increased. An interesting question is how involved or complicit were regulators during this time? They also were under tremendous pressure at the time to stabilize the whole financial system.

One thing you can count on in finance is contagion. The scandal has already spread from Barclays to other large banks that are under investigation or face lawsuits alleging LIBOR was manipulated. In Britain, the Financial Services Authority is involved, in the U.S. the Department of Justice and Commodities Futures Trading Commission, and Brussels in the E.U.

The LIBOR mess will be in the news for years to come. But it is not the only financial instrument to set rates by survey. There is TIBOR (Tokyo Interbank Offered Rate) and EURIBOR (Euro Interbank Offered Rate) that are similar to LIBOR. Many swap prices are also set by survey as well as other financial instruments.

LIBOR is the most important short-term interest rate in the global financial markets as the 10-year Treasury bond yield is for longer-term interest rates. The problem is that LIBOR does not reflect market prices or transactions as does the 10-year U.S. Treasury bond yield. Going forward, LIBOR and its equivalents should be based upon actual rates and prices at which banks have lent to or borrowed from one another, not estimates. At this time, LIBOR transactions are not publicly reported so there is a lack of transparency. There may not be current prices each day for all 150 LIBOR quotes but reported transactions should be the starting point, and that data used to fill in the blanks for those quotes not having transactions.

LIBOR has been around since the 1980s and has become one of the most important rates in the financial markets with huge financial implications for consumers, corporations and governments. And the market has been under suspicion of being manipulated for several years, but regulators never seriously investigated until recently. It is obvious that the present process of computing LIBOR is deficient. Given the amounts involved, the incentives to manipulate it are too large. Banks should not be able to profit from the level of LIBOR set by the banks themselves.

LIBOR may end up being the largest financial scandal of all times, given the trillions of dollars impacted by the rate. As mentioned previously, LIBOR will be in the  news for years to come. But what a global financial calamity it would be if LIBOR were to collapse. Hopefully in the future a better process can be devised to set a benchmark short-term interest rate that all lenders and borrowers can have confidence in as a real rate and not an artificial rate.

There may be alternatives to LIBOR. Some would suggest U.S. Treasury bills which are owned globally and traded in a liquid and efficient market. But they are subject to the creditworthiness of one country as opposed to 18 global banks. Another possibility would be to use the repo rate, which is the rate for financing securities. The borrower puts up securities for collateral for a loan and agrees to repurchase them at a later date at a specified price. So don’t be surprised if something replaces LIBOR.