LIBOR Scandal and How Banking Institutions Set their LIBOR Rates - Case Study Example

The Libor Scandal The Libor Scandal An introduction to the LIBOR and how Banking s set their LIBOR Rates The London Interbank Offered Rate (LIBOR) refers to the reference rate at which large banks designate their ability to borrow short-term wholesale funds from each other on loose basis in the interbank market. In other words, LIBOR refers to the average interest rate that is estimated by prominent banks in London that determines how much a bank should pay in form of interest if the bank borrowed money from another bank. Initially, LIBOR was known as BBA LIBOR just before the responsibility for fixing the interest rates was transferred to Intercontinental Exchange. LIBOR, along with the Euribor, are the primary benchmarks for short term interest around the world. The calculation of LIBOR rates occurs with the consideration of 15 borrowing periods that range from overnight to one year. In 2007, however, regulators noted that LIBOR no longer observed or behaved according to the expectations set fourth for them in relation to market prices and rates. Investigators from the US and other foreign regulators conducted investigations and uncovered unequivocal manipulations whereby banks were influencing fixing of interest rates so that they can project financial soundness during the economic crisis and thus benefit the exclusive trading positions offered by the directives (Abrantes-Metz 2012). It is this scandal that this paper will be looking deeper into exploring its causes and the impacts it had on the global arena. Member banks are essentially international in scope. As of 2008, there were over sixty nations represented in LIBOR. Since its inception, the LIBOR has grown to becoming the reference rate for not only commercial fields but in the financial market. Around the same year, the US had over 60 percent of its prime adjustable-rate mortgages and almost all its subprime mortgages being index to the US dollar LIBOR. Other than that, at least 75 percent of money borrowed by American municipalities was borrowed through products that were linked to the US dollar LIBOR. The UK and Switzerland also use their own versions of LIBOR, measured in their own domestic currency. These facts underscore the importance of the LIBOR and how its instability can be devastating to the global market. Thomson Reuters calculate and publish LIBOR on behalf of the British Bankers Association (BBA) (Hou & David 2014). The index is supposed to measure the cost of funds to global banks that operate in either London-based counterparts or London financial markets. Every day, the BBA surveys 18 major global banks for the US dollar LIBOR. It asks the panel the rates the banks would borrow funds from their fellow banks, at a reasonable market size of course (MacKenzie 2008). After asking the question and receiving replies from the panel, the British Bankers Association throws out the lowest 4 and the highest 4 averaging the remainder which consists of the responses from the 10 banks and then yielding a 23 percent trimmed mean. For each of the 10 currencies of the LIBOR, there are 15 different maturities for the LIBOR set of indexes. The US has chosen the 3 dollar US LIBOR which is principally the index that result from asking the panel the rate they are willing to pay if they borrowed money for 3 months. The Role of LIBOR in the Commercial Sector There are two main purposes that LIBOR serves in modern markets. One, it serves as a references rate and two, as a benchmark rate. As a reference rate, financial instruments contract upon so as to establish terms of agreement. A benchmark rate, on the other hand, reflects a relative performance measure sometimes of funding costs but at other times for investment returns. The LIBOR serves a very crucial purpose as a reference rate for short-term financial contracts floating rate such as futures and swaps. The contracts are estimated to be at upwards of $300 trillion in value (Abrantes-Metz & Evans 2012). Adjustable rate mortgages (ARMs), Variable rate loans, and also private student loans are all tied to the LIBOR. As a benchmark, the LIBOR also indicates the health of the financial markets. If there is a huge discrepancy between the LIBOR rates and other benchmark rates, then it can be taken as signaling huge changes in the financial environment. Since the LIBOR is primarily based on the rates at which other major banks can obtain funding on a short-time basis, the index serves as the lower bound of other less sound banks (in terms of their creditworthiness that is). Normally, rates are expressed as “LIBOR + x”. The x denotes the premium charged for each and every borrower on top of the LIBOR rate in relation to its corresponding maturity term, basis points, and creditworthiness of the lender. The importance of the LIBOR as a reference point is, therefore, very important in the financial market. If banks can tie their cost of funds (with a positive premium built in) to the interest rates they charge, they can secure themselves positive net interest margins. This advantage offered by relating the ARMs, interest rate swaps, and fixed income securities to the LIBOR is the reason the benchmark is so popular and is prone to manipulation by the banks involved in its formulation. The Impacts of the LIBOR on Business and Consumers As mentioned above, the LIBOR is a very important benchmark in the financial sector. The fact that most banks set their interest rates based on those submitted by major international banks makes the benchmark even more favorable. Generally, most banks do not submit high rates in for the indexing of the LIBOR as that is translated as the bank going through a hard time financially. The likelihood of most banks submitting reasonable rates means that they do not draw attention toward themselves which may work as a benefit to consumers who borrow money from banks that set their interest rates using the LIBOR. The benefit to the consumers in that the interest rates will not be high. To the consumers, the LIBOR may be of benefit to them. Unfortunately, manipulation of the LIBOR by Barclays as will be discussed below can give the wrong impression that the fiscal condition of the world’s economy is strong yet things are not good with the banking system. Banks can therefore charge low trying to adjust their interest rates with the LIBOR and end up making losses. The LIBOR Scandal The economic recession of the year 2007 was one of the reason banks that were struggling financially sought to make profits through the simple manipulation of the LIBOR. Investigations on one of the most powerful banks in the world, Barclays, revealed that the firm had engaged in two types of LIBOR manipulation. The first form of manipulation involved Barclays requesting that the LIBOR be manipulated so that the process can benefit the derivative traders. The second form of manipulation involved submitting false rates during the economic recession so that Barclays’ reputation is not affected. The manipulation of the LIBOR in 2008 by Barclays has unclear impacts on the part of the bank. However, the firms that the bank colluded with, or rather its traders, stood to benefit from the manipulation as it reduced their losses transferring that to their counterparties. In June 2012, Rabobank, UBS, Barclays, and the Royal Bank of Scotland had colluded to submit low LIBOR rates for their own benefit. It was estimated that this had started since 1991, a few years after LIBOR was introduced. As this paper had mentioned earlier, the LIBOR rate is an important factor in the referencing of derivatives as the derivatives are worth trillions of dollars. Generally, the major banks that are responsible for determining the LIBOR rates are the same banks that deal with these colossal amounts of money worth of derivatives. The traders of these banks colluded to submit fraudulent LIBOR rates daily so that they could boost their profits on their derivatives positions and give a false impression of their current state of finance during the financial crisis that had hit the world. Normally banks hold huge amounts of derivatives and loans meaning that a miniscule change in the LIBOR rate can equate to millions of dollars of profits or losses. If the LIBOR was manipulated in favor of any large banking institution, even by 0.01 percent, the bank could make millions of dollars as profits. Unfortunately, all the profits that these banks made did not come from anywhere else but from other unwitting financial institution that were on the opposite side of the trade. The U.S. homeowners paid higher mortgages while the U.S. municipal governments, on their derivative hedges, lost about $10 billion to the manipulations (Baba, McCauley, & Ramaswamy 2009). The realization that huge financial institutions were manipulating the LIBOR for their own benefit during the economic uncertainties that prevailed acted as a huge blow to the confidence people had on the global financial institutions. The impact was so devastating that the LIBOR had to undergo a lot of changes and policy development including the passing of a bill in the U.K that demanded that the LIBOR be controlled by the government. These were efforts to ensure that such fraudulent acts do not happen again. The banks involved were also dealt a huge blow for their malevolent actions. They paid a total of $6 billion as fine as 12 people were pressed for criminal charges. Other than that, it is estimated that the banks may have to pay about $35 billion dollars as legal settlements in the long run in addition to paying the regulatory fines (Rayburn & Cowden 2013). Conclusion The LIBOR is inarguably the most important number in the world. If it was altered, then the results could be devastating to the world’s economy as a small change in its value translates to trillion of dollars when equated to the global economy. While it is important to have a given index that the global economy can use, having a few financial institution control its value can be very dangerous to the health of other firms. It is because of the fact that the institutions controlling its value can decide to manipulate it as seen with Barclays, UBS, and the others, which can otherwise bring huge losses upon other financial institutions and the general population. The decision of the U.K. government to control the LIBOR was a good step toward the right direction as it would ensure no banks take advantage of their position in the indexing process. References Abrantes-Metz, Rosa M., and David S. Evans. Will the Wheatley Recommendations Fix LIBOR? CPI Antitrust Chronicle, 2012 Abrantes-Metz, Rosa M., et al. Libor manipulation? Journal of Banking & Finance 36.1, 2012 Baba, Naohiko, Robert N. McCauley, and Srichander Ramaswamy. US dollar money market funds and non-US banks. BIS Quarterly Review, 2009 Hou, David, and David R. Skeie. LIBOR: origins, economics, crisis, scandal, and reform. FRB of New York Staff Report 667, 2014 MacKenzie, Donald. What’s in a number? The importance of LIBOR. Real-world economics review, 2008 Rayburn, C., and W. Cowden. LIBOR Scandal and Litigation: How the Manipulation of LIBOR Could Invalidate Financial Contracts, The. NC Banking Inst. 17 (2013): 221. Read More