Li(e)bor

In my last post I lamented the apparently non-existent moral foundations of banks. I hardly thought the next scandal would be so soon after. Last month it transpired that Barclays had been manipulating the Libor rate. However, everybody else was doing it too, it seems. This is a betrayal of public trust egregious enough, in my opinion (and many others’), to warrant some jail sentences.

But everybody’s doing it

Bankers never seem to do anything alone. Everybody has to have their piece of the pie. No one is willing to stand out, even for the sake of such things as moral principles, ethics, right and wrong. After Barclays was fined a paltry amount it became clear that they were not the only ones involved. A large list of banks is now under investigation. Were they colluding? Probably, but not necessarily. I will discuss this further below. First, let us get a grip on what this mysterious Libor is.

What is the Libor?

Libor, actually LIBOR , is an acronym for London Interbank Offered Rate. It seems to be an interest rate. Actually, it is not, which is part of the problem. It should, however, in principle at least, be related to actual interest rates. The interest rates referred to are the rates banks charge each other when they lend money to each other. It is a common occurrence for a bank to lend money to another bank, for instance if the latter bank needs liquidity in the short term. The Libor is calculated more or less as follows. A number of banks (16, it seems) are asked to give an estimate of the rate at which they could borrow money from the inter-bank market. The top and bottom quarter of these estimates are thrown out and an average taken of the ones that remain. This is the Libor. The problem with the above process is that it is open to manipulation. It is subjective, which makes it easier (and more tempting) to lie. This, then is what Barclays did. What many banks did.

Why does it matter if Libor is wrong?

Libor might not be an actual interest rate, but many (very many) actual interest rates are based directly on Libor, from mortgage rates to rates on derivatives known as swaps. If Libor is low it means those with mortgages related to Libor pay lower amounts. They win. However, people invested in instruments that pay rates related to Libor lose out as they get less. These may not even out. The impact of a single basis point difference in Libor is a huge redistribution of wealth. Libor matters not only because of instruments it affects directly. It has become a global benchmark interest rate. It is taken into account in many decisions. It could affect many other rates charged, advice given, corporate actions taken. The Libor is also an indicator of the health of the banking system. When it is high, it indicates banks have little faith in the ability of their peers to repay their money. An artificially low Libor rate is, in effect, a collective denial of the fragility of the banking system. It is serious if such a globally significant figure is a lie.

Why try to manipulate Libor?

1. In order to look better. For a time Barclays’ submitted Libor figures were higher than the rest of the market. This, seemingly, indicated that Barclays was in relatively poor health. Lowering its Libor estimates alleviated these fears.
2. Because everybody else is doing it. Why were the other banks’ Libor estimates so low? Possibly because they were underreporting them. Barclays may not have been the first to do so. The more banks that underreport their Libor the more pressure there is on other banks to do the same in order not to seem weak. In addition, if everybody else is doing it, it is far easier to delude yourself into thinking it is acceptable. You can defend yourself by pointing fingers. 
3. Profit. Profit. Profit. Emails between those responsible for the submission of Libor and traders show agreements to attempt to manipulate Libor in order to favour the traders’ positions. For instance, suppose Barclays held a swap contract in which they agreed to pay a the Libor rate to another party and, in return, received a fixed rate¹. If the Libor rate falls, the bank’s position becomes more valuable as it is now paying out a smaller amount, but still receiving the same fixed amount.

What does it matter if Barclay’s Libor is wrong?

Barclays is only one bank. Does it really matter if its Libor submission is wrong? Well, yes and no. If Barclays submission is too high or too low it does not influence the calculated result at all. However, every bank’s submission influences every other banks’ submission. None of the banks would want to seem too weak compared to the others. This can lead to seemingly co-ordinated underreporting of Libor even if the banks are not colluding explicitly. This, however, is really only relevant for reasons 1 and 2 above. To profit from Libor rigging, Barclays would need to be able to move the rate on its own, unless it colluded with other banks which had similar positions.

Let us suppose Barclays’ estimate is not thrown out, so it is one of the eight estimates that do get averaged. What is the effect of Barclays’ estimate? Suppose the average of the other 7 banks is x and the Barclays estimate b (in per cent), then the average of all 8 is 7/8x + b/8. How much lower than the average of the other banks would Barclay’s estimate need to be in order to lower the Libor by 1 basis point, that is by 0.01? Solving a simple linear equation gives that Barclays’ estimate should be 8 basis points lower. Conversely, to push up Libor by one basis point, Barclays’ estimate needed to be 8 basis points higher. To give a little more perspective: In 2005/6 Libor was around 5% at times. If Barclays’ wanted to lower the Libor to 4.99, it needed to submit an estimate of 4.92. It might not have needed to manipulate it any more than that to profit. Now, I am no expert on Libor rates or their spreads. It may be that the spread in Libor estimates was high enough to allow Barclays’ estimate to be included in the average. In any case, presumably those submitting the rates would know more or less, from experience, what kind of range of values are usually submitted and adjust the submission accordingly. So, it seems that it was possible for Barclays’ to manipulate Libor, albeit in a somewhat limited fashion. It also appears that traders did in fact collude so that several banks altered their submissions simultaneously. This would have a far greater influence on the Libor estimate.

Should bankers go to jail?

Yes. This is an example of fraud (albeit committed by almost an entire industry). I hope to see several people behind bars for this. However, whether that will happen, given the widespread nature of the fraud and the possible difficulty in assigning culpability, I do not know. What is clear is that the fines imposed for this kind of behaviour are ineffective. They do not even make a dent in the Banks’ balance sheets. Lawsuits against Barclays may do more damage, though.

Are regulators also to blame?

It seems that regulators knew Libor was incorrect for quite some time. And did nothing. In the midst of the financial crisis they probably thought there were more pressing concerns. Perhaps they just did not want to believe that what they were told was true, and so they didn’t. Bernanke apparently knew of the troubles with Libor and told the British regulators, who did not take it seriously. So the British regulators are clearly at fault. However, morally, Bernanke is too. Here is one of the greatest financial scams in history, affecting millions of people, and you keep silent, you don’t make a public statement, you don’t force a resolution. You say in the gentlemen’s club. Something similar can be said of Tim Geithner, president of the New York Fed at the time the rigging occurred.

What to do?

Of course, Libor is now useless. I think the best thing to do would be to replace it with a similar rate, but based on actual transactions. This has been suggested by others. Of course, everyone is calling for tougher regulation. Probably, the entire structure of regulating bodies will need to be changed. It’s no use for there to be good regulation if it is not enforced. The relationship between regulators and the industry is clearly not working. Perhaps we should all start putting our money in Triodos. At least these bankers seem to have a conscience. Or perhaps we should just mutualise all the banks. No more shareholders and banks owned by depositors. Less profit motive. Perhaps the incentives would be less perverse, but honestly, I am not sure. Ideally, people would grow spines, come to believe in a higher power, or just start caring about other people, but that won’t happen.

Post-apocalypse

We have not, it seems, heard the last of this particular scandal. The investigation of other banks is going to take a while and will, hopefully, unearth some corpses. A good article says the following:

The unpalatable message of the crisis and Diamond's actions – or inaction – is that financial institutions can't be trusted to not act foolishly in pursuit of their own self interest, and that the only question is how frequently they do so and how grave the consequences prove to be either for their shareholders or for the financial system as a whole.

Banks have demonstrated time and again that they are devoid of moral rectitude, that they act selfishly and (economists would rejoice) rationally in the face of temptation. And why should they not? We always let them off the hook. As one article puts it “there’s something rotten in banking.”

References

News 

• Barr, R. (2012). Former Barclays exec admits false LIBOR submission. Newsday. Retrieved July 18, 2012, from http://newyork.newsday.com/news/region-state/former-barclays-exec-admits-false-libor-submission-1.3840836 
• Barrow, B., & Davies, R. (2012). Bob Diamond DID give orders to cut Libor, claims Barclays executive . Mail Online. Retrieved July 18, 2012, from http://www.dailymail.co.uk/news/article-2174614/Bob-Diamond-DID-orders-cut-Libor-claims-Barclays-executive.html 
• Bloomberg. (2012). There’s Something Rotten in Banking . Bloomberg View. Retrieved July 18, 2012, from http://www.bloomberg.com/news/2012-07-02/barclays-case-shows-something-s-rotten-in-banking-culture.html 
• Bloomberg News. (2012). NY among states probing interest-rate fixing. Newsday. Retrieved July 18, 2012, from http://newyork.newsday.com/news/region-state/ny-among-states-probing-interest-rate-fixing-1.3843206 
• Crutsinger, M. (2012). Bernanke: Fed had no power to change LIBOR. Newsday. Retrieved July 18, 2012, from http://newyork.newsday.com/news/region-state/bernanke-fed-had-no-power-to-change-libor-1.3843208 
• DuBois, S. (2012). The Barclays school of crisis management. CNN Money. Retrieved July 18, 2012, from http://management.fortune.cnn.com/2012/07/03/the-barclays-school-of-crisis-management/?iid=SF_F_River 
• Farrell, M. (2012). Barclays: Don’t just blame us! CNN Money. Retrieved July 18, 2012, from http://buzz.money.cnn.com/2012/07/03/barclays-libor-investigation/?iid=EL 
• McGee, S. (2012). The Big Questions Raised by the Barclays Scandal. The Fiscal Times. Retrieved July 18, 2012, from http://www.thefiscaltimes.com/Columns/2012/07/05/The-Big-Questions-Raised-by-the-Barclays-Scandal.aspx#page1 
• Morris, N. (2012). Other banks face bigger fines on rate fixing, warn Barclays directors. The Independent. Retrieved July 18, 2012, from http://www.independent.co.uk/news/business/news/other-banks-face-bigger-fines-on-rate-fixing-warn-barclays-directors-7945444.html 
• O’Toole, J. (2012). Explaining the Libor interest rate mess. CNN Money. Retrieved July 18, 2012, from http://money.cnn.com/2012/07/03/investing/libor-interest-rate-faq/index.htm 
• Reuters. (2012). RBS set for fine as Barclays boss remains defiant. The Fiscal Times. Retrieved July 18, 2012, from http://latestnews.thefiscaltimes.com/2012/06/28/uk-banks-face-new-scandal-barclays-boss-in-peril/ 
• Reuters. (2012). Barclays takes rate fixing scandal hit. Business Report. Retrieved July 18, 2012, from http://www.iol.co.za/business/international/barclays-takes-rate-fixing-scandal-hit-1.1341163 
• Rosenberg, Y. (2012). Libor-gate Explained: Why Barclays’ Scandal Matters. The Fiscal Times. Retrieved July 18, 2012, from http://www.thefiscaltimes.com/Articles/2012/07/06/Libor-gate-Explained-Why-Barclays-Scandal-Matters.aspx#page1 
• Sky News. (2012). Barclays Was “In Denial” Over Rate-Fixing. Sky News HD. Retrieved July 18, 2012, from http://news.sky.com/story/961370/barclays-was-in-denial-over-rate-fixing

An interesting blogger

• Doyle, L. (2012). Barclays Libor Scandal: Reports Regulators Knew; Time for Independent Investigation and Eliot Spitzer. Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-reports-regulators-knew-time-for-independent-investigation-and-eliot-spitzer/ 
• Doyle, L. (2012). Barclays Libor Scandal: When Did Manipulation Start? Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-when-did-manipulation-start/
• Doyle, L. (2012). Barclays Libor Scandal: Who’s Really to Blame? Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-whos-really-to-blame/ Doyle, L. (2012). Barclays Libor Scandal: “Diamond Lied.” Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-diamond-lied-to-the-committee/ 
• Doyle, L. (2012). Barclays Libor Scandal: Holding Regulators to Account. Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-holding-regulators-to-account/ 
• Doyle, L. (2012). Barclays Libor Scandal: The Precedent. Sense on Cents. Retrieved July 18, 2012, from http://www.senseoncents.com/2012/07/barclays-libor-scandal-the-precedent/#more-30091
• Doyle, L. (2012). Barclays scandal: How big will this get? CNN Money. Retrieved July 18, 2012, from http://finance.fortune.cnn.com/2012/07/03/barclays-libor-scandal/?iid=EL 

Some graphs 

• FedPrimeRate.com. (2012). LIBOR rates: Historical Charts. FedPrimeRate.com. Retrieved July 18, 2012, from http://www.fedprimerate.com/libor/libor_rates_history-chart-graph.htm 

Wikipedia

• Wikipedia. (2012). Libor scandal. Wikipedia. Retrieved July 18, 2012, from http://en.wikipedia.org/wiki/Libor_scandal

1 This is a common arrangement. An organization may for instance have a variable rate loan which it needs to repay with a floating interest rate. In order to make its costs more certain, it can enter a swap contract with a bank, pay a fixed amount every month and in return the bank will pay the interest on the loan.