Rigging the LIBOR

The British banking regulator FSA has prosecuted Barclays for rigging the interest rates in the market. The regulator termed it as being equivalent to stealing money from people who invest in derivatives and other stock market instruments that are sensitive to LIBOR.

Barclays, one of the largest banks in the United Kingdom had to pay over 290 million GBP to settle the issue out of court. Barclays is not the only one being sued for this massacre. All major European banks and even some big American banks have been accused of defrauding the investors in this gigantic scandal. In this article, we will study the details of how these banks rigged LIBOR and used it to their advantage.

What is LIBOR ?

London Interbank Offered Rate (LIBOR) is a benchmark interest rate that is used across the world. For instance, if your mortgage is variable it is usually expressed as LIBOR + 2% and so on. London is considered to be the nerve center of the modern financial system. Hence, the confidence that banks have while borrowing and lending money in London is considered to be a proxy for general confidence in the financial world.

Hence, if banks in London are willing to lend money to each other at low rates of interest, then we have a healthy economy. A rise in LIBOR causes a rise in all the other interest rates linked to it. This has a recessionary effect on the economy.

The Huge Flaw in LIBOR calculation

LIBOR was earlier calculated based on the estimates given by the major banks in London. They estimated the rate at which they were willing to lend money to other banks for overnight transactions. A central body would compile this information and the average derived was the LIBOR i.e. the benchmark interest rate that could literally move the world!

The huge flaw with this approach was that estimates were being used to arrive at the LIBOR. Hence nobody had to actually borrow and lend at the rate mentioned in LIBOR, the banks merely had to tell the regulator that they would do so. In practice they would be borrowing and lending at completely different rates. Banks therefore realized that they could form a cartel and rig the LIBOR in their favor. For a couple of years, the LIBOR number would be whatever the banks wanted it to be.

Why Rig Interest Rates ?

The ability of the banks to rig interest rates has been mentioned above. However, why would they want to do such a thing? Well, the answer lies across the Atlantic. United States is one of the largest derivative markets in the world. The notional value of the derivative contracts traded on American exchange is over $350 million and almost all of them are based on the LIBOR. Even the change of a few basis points in LIBOR causes billions of dollars to be made in profit. It was therefore no surprise that banks that could rig the LIBOR also had huge positions in the derivatives markets and also an enviable record of stellar success.

Effects on Consumer Markets and Financial Markets

The FSA termed the interest rate rigging as being similar to robbing common people. The reason for this statement is as follows:

• Expensive Mortgages: Banks would ensure that all variable rate mortgages reset in the first week of the month. These variable mortgages were dependent on the LIBOR. These banks would then rig the LIBOR to be artificially high in the first week of the month. This is because the LIBOR rate on the reset date is the basis on which people have to make their mortgage payments. An artificially higher LIBOR therefore translates into higher interest payments received from the people. This is literally equal to stealing money.

• Lost Public Money: Government agencies issuing bonds have also been ripped off by banks looking to make a quick buck. They advised these local government bodies to issue bonds at a variable rate which was lower than the prevailing fixed rate. To cover the risks of borrowing at a variable rate, these investment banks arranged for swaps. The banks or their crony companies were at the other end of this swap. They would offer fixed rates to the banks. Since they could drive the LIBOR high, they were the ones that benefited when the rates went higher. The municipalities did not lose money out of pocket but they definitely lost money in the form of opportunity costs.

Changes after the Scandal

When the lid was blown off the LIBOR scandal, the FSA was forced to make several changes to protect common people that were being ripped off by the banks. The changes are as follows:

• Calculated as per Actuals: LIBOR is not calculated based on actuals and not on estimates. This means banks do not have to merely quote rates they feel would be appropriate. Instead, they are supposed to transact at that rate. The average of the transactions (not the estimates) is the LIBOR.

• Criminal Offence: Also, the FSA has made rigging the LIBOR a criminal offence. Any bank that indulges in such activities would face massive monetary fines as well as possible suspension of their banking licenses.

The LIBOR scandal is just one of the reasons why the common man has absolute mistrust for bankers and the banking system.