Introduction
Libor is the most followed and used transaction rate in the world. This rate is used by banks to give bank loans and transfers, mortgages, futures market, credit cards and lot of other financial instruments. Over the years Libor has dominated the international financial system rates. Around 2007, when the recent financial meltdown started some of the banks started quoting Libor absurdly low or sometimes high depending on the situation. It created an artificial Libor rate in the market which was far away from the actual rate. This created problems for all the parties involved in financial market. This essay will discuss in detail what is Libor, the Libor scandal, effect of the scandal and how it was solved.
What is LIBOR?
The London Interbank Offered Rate abbreviated to LIBOR is globally the most busy interest rate market in which the average interest rate at which the leading banks of London would borrow from each other is determined. The rates are also decided for other financial derivatives including swaps, interest rate futures and Eurodollars. The rates are calculated for ten currencies including US dollar, Australian dollars, Canadian dollars, euros, British pounds sterling, New Zealand dollars, Swedish kronor, Danish kroner, Japanese yen, and Swiss francs in the London interbank market for 15 borrowing terms ranging from one year to overnight. These report rates are then published by Thomson Reuters every day in the morning at 11.30 am London time.
The Libor Scandal
The Libor scandal took place when the banks started inflating and deflating their interest rates as they deem fit in order to accrue more profit out of trade deals thereby giving a false impression of their credit credibility. Libor supports financial transactions and deals worth $350 trillion. BBA or the British Bankers' Association oversees Libor. In the London interbank market the participating banks are supposed to report the actual interest rate at which they would borrow from other banks. Libor is the benchmark of short term interest rates that determines the overall health of the entire financial system. Usually banks submit lower rates when they have confidence in the financial state of affairs and submit higher rate when their confidence in the financial system is shaken. But in the wake of the last recession in 2007 in global financial economy many member banks of BBA were seen to have manipulated the Libor rates by submitting lower and higher rates than the actual estimate, leading to one of the worst financial scandals in recent years.
Several banks are currently under investigation for Libor rigging including HSBC, Deutsche Bank, Citigroup, Barclays, UBS, Royal Bank of Scotland, and JPMorgan. Of all these banks, British Bank Barclays' contribution is noteworthy. Barclays has been involved in the Libor rigging since 2005 having reportedly manipulated dollar Libor and Euribor rates responding to the requests of its derivatives traders and other banks. As per the report submitted by FSA, the derivatives traders of Barclays placed 257 requests for Libor and Euribor rigging. There are two reasons behind Barclays rigging the Libor rates - 1) to project a health image of their bank during the recession and 2) to better their finances. Following the scandal, the chief executive of Barclays Bob Diamond and the chairman Marcus Agius resigned from their posts. Barclays also incurred a hefty fine of £290m in June 2012.
Apart from Barclays which was one of the biggest offenders, UBS was also fined $1.5 billion by UK and US government agencies. Deutsche bank also informed its investors and customers that it was preparing itself for Libor litigation process and keeping aside $1 billion to pay as penalties. Royal Bank of Scotland is also close to a settlement. However, there is a strict instruction from the exchequer of UK that the whole amount of fine should be paid by the bankers without affecting the investors’ money.
Effect of Libor Scandal
The Libor scandal has also affected the pension income of retirees and future retirees. The interest rates having kept artificially low by the banks has decreased the value of mortgage-backed securities of pension earners and as a result the interest accrued from those securities has reduced.
Libor Scandal also affected people who borrowed loans from the banks. People who borrowed student loans or mortgages during the time the Libor rate was set at artificially low rate might have benefitted but those who borrowed at the time when Libor rate was fraudulently set at higher rate have been affected. Similarly lenders and investors who have invested money have suffered due to fraudulent lowering of interest rates. Recently a lawsuit has been filed by New York lender Berkshire Bank against 16 banks involved in rigging the interest rates.
British Government Solution to Libor
After the Libor scandal became public, there was a huge outcry for elimination of Libor altogether. But due to its importance in setting benchmark interest rate for government and corporate loans and other financial derivatives, the British government decided to save it. The British government made a proposition to undertake the supervision of Libor from BBA. FSA initially suggested that the Libor rate in future would not be monitored by BBA and it would be monitored by some exchange or third party data provider like Reuter or Bloomberg. FSA also suggested against using the suggested rates of banks as Libor rate. It proposed that LIBOR should be pegged to some actual market rate instead. As per the final proposition, the banks would still submit the daily Libor rate but in addition they need to show that the rates submitted accurately reflect their actual borrowing costs. The government would publicly report the submitted rates with a three month lag to prevent the banks from lying about the actual costs under stress. The government would also levy criminal charges on banks misreporting. In order to focus more objectively on the interest rates important in the market, currencies of Australia, New Zealand, Canada, Denmark and Sweden and four maturities would be eliminated. Further out of 150, only 20 Libors that have the utmost importance to participating banks would be retained (John Kiff, 2012). The final rules and regulations are still under discussion. In coming days we will see a more robust and strict Libor rate governance.
Conclusion
Libor was the main rate for all the interbank rates and many other money market and derivative related rates. After the scandal, lots of countries and financial authorities have started questioning the accuracy and sanity of Libor rate. If Libor is so easy to fix then it cannot be used as a global banking baseline rate. Some of the bigger banks during 2007-2008 have shown that fixing of the Libor rate is easy. They lowered and increased the interest rate artificially, causing a lot of investors lose money. It also gave a false picture of growth and stability when actually some of the participating banks were not doing well financially. BBA and US Fed understood the current system of Libor rate determination was flawed and the overall process needed a complete revamp. BBA and US Fed came up with a more transparent process. The current process requires logic behind the rates at any time and it is no longer susceptible to manipulation. Banks need to substantiate their rate quote based on their borrowing costs. Also the British government will publish the rate to all after three months. Hopefully the scandal has made BBA and other financial governing bodies a lesson. In future the rule should be so transparent and strict that no bank will be able to fix the rate as it wishes.
References
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