Watching the dominos fall in the LIBOR crisis

The UK’s LIBOR system was designed to be transparent but difficult to game: so what happened? AAP

Imagine if we discovered that the monthly setting of the Reserve Bank of Australia’s cash rate was rigged.

There would quite rightly be outrage. We trust the RBA Board to make these calls, month after month, impartially, for the general good of the Australian economy.

Such a breach of trust is precisely what happened in the UK’s LIBOR scandal.

It is now clear that Barclays Bank, which was fined a total of $450 million earlier this year, wasn’t alone. Overnight the news has broken that UBS has been fined $1.5 billion for LIBOR rigging over several years and involving dozens of staff.

Last week, a former Citigroup trader was arrested by police as a result of the scandal and the UK Serious Fraud Office (SFO) has taken charge of investigations. In the same truly terrible week for one of the world’s largest banks, HSBC (which was hit by a separate $1.9 billion fine for money laundering by US regulators) has set aside millions to cover the costs of the LIBOR scandal.

Elsewhere it has been reported that JPMorgan, Royal Bank of Scotland have been subpoenaed by US authorities.

What is LIBOR?

Like the Official Cash Rate, LIBOR (London Inter-Bank Offer Rate), is not an actual rate at which banks borrow or lend but a “reference” or “benchmark” rate against which borrowing or lending rates are set, often in a form such as LIBOR + 1.5%. LIBOR is meant to represent the borrowing rates between banks in the London Money Markets.

Unlike the RBA cash rate, however, LIBOR is not set by an official body such as the Bank of England, but by the industry itself in a process coordinated by the British Bankers Association (BBA), giving rise to the correct terminology bbalibor.

There is not one LIBOR rate but 150 different rates, covering 10 currencies (including the Australian dollar) at 15 different “maturities”. Maturity here refers to the period covered by a specific LIBOR rate, ranging from “overnight” to one week, two weeks, one month, two months and so on up to 12 months.

The genesis of LIBOR can be traced back to the mid-1980s, when trading in so-called Forward Rate Agreements (FRA) started to grow. Interest Rate Derivatives (IRD), such as FRAs, are very powerful tools allowing businesses to “lock in” future interest rates. The rapid growth of this market prompted banks to standardise the rates and terms of these contracts, giving rise to LIBOR as we know it today.

In theory the process is designed to be a relatively transparent process that should be difficult to game.

For a particular currency and maturity LIBOR is set by a “contributing panel” of banks, each of which is asked each day to answer the same question: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

Their answers, which are confidential, are collated by Thomson Reuters, and averaged (after “trimming” the highest and lowest 25% of contributions) to arrive at the official rate for each maturity, which is then published on the BBA LIBOR market page at 11am each day. (There is a different panel for each currency although the major international banks, such as JP Morgan, appear on many panels).

Who uses LIBOR?

While many business loans and even some floating rate mortgages in the UK and USA use LIBOR as the reference rate, the market for Interest Rate Derivatives based on LIBOR is estimated at $300 trillion. (Compare this to the annual global GDP estimated by the World Bank at $70 trillion.) However, it should be noted this is the “notional” or face value of such transactions and does not (because of netting or offsetting) represent the market value, but is nonetheless staggering.

So what went wrong?

Earlier this year, as a result of a UK parliamentary inquiry, it was revealed that in 2008, US and UK regulators suspected Barclays Bank had been submitting lower values than would be expected for its estimates of LIBOR during the height of the Bear Stearns crisis in August 2007. Why would Barclays do that? Always remembering that LIBOR represents what a bank thinks it’s own likely borrowing costs will be, by low-balling the bank will give the impression that it is safer that it may actually be. It is an act of bravado! Barclays denied any wrongdoing.

Former Barclays chief Bob Diamond denied wrongdoing but had to resign.

Believing that rates are being manipulated is one thing, proving it is another. In 2008, the Bank for International Settlements (BIS) published the results of a study into questions around interbank rate fixing. The regulator’s study concluded while there was a wider range of estimates between banks than would be expected, LIBOR “worked as intended”. Though disputed by some experts, in particular the Wall Street Journal, the BIS view was endorsed by no less than the IMF.

Enter the whistleblower

In an interview with the Independent newspaper, an anonymous whistleblower stated borrowing rates had been manipulated in 2008 and that senior management, including Bob Diamond, the abrasive boss of Barclays, would have known.

Coupled with the announcement of a fine from the Financial Services Authority (FSA) for inappropriate LIBOR submissions, this was curtains for Diamond, who having fronted a parliamentary committee claiming no knowledge of the practice of fixing LIBOR, was forced to resign.

Barclays Chairman Marcus Agius also resigned, preceded by Chief Operating Officer, Jerry del Missier, who had admitted to the parliamentary inquiry that manipulation had taken place but, in a novel defence, claimed Paul Tucker, the Deputy Governor of the Bank of England, had encouraged him to do it. Tucker denied this, but the controversy subsequently stymied his chances of replacing Sir Mervyn King as the Governor.

Deputy BoE Governor Paul Tucker denied telling Diamond to rig the LIBOR.

Enter the emails

In reporting its fine for Barclays, the FSA documented numerous emails and phone calls from Barclays traders to submitters requesting low or high submissions should be made (depending on the need to raise or lower rates).

One egregious example sums up the casual way that business was conducted. In 2006, a Barclays trader received an email from an external trader requesting a lower submission on 3 months USD LIBOR, “If it comes in unchanged I’m a dead man”. Later in the day, obviously happy, the external trader emailed, “Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger”.

Potentially many hundreds of thousands of loans were made at rates that were too high and as a result businesses and borrowers may have paid millions - even billions - too much for their loans. All the while, the banks involved reported billions in profits and gave millions in bonuses to individual traders.

What next?

In September this year, Martin Wheatley, soon to be head of the new UK Financial Conduct Authority (FCA) published a report into the LIBOR scandal. The report concluded the current system should remain substantially unchanged but with additional regulations put in place and new criminal sanctions be introduced for market manipulation. The report also recommended the LIBOR process be taken away from the BBA.

Along with the GFC, PPI scandal and money laundering outrages, the LIBOR scandal is yet another example of the banking industry breaching the trust placed in it by its customers and the general public. The Economist - not usually known for biting the financial hand that feeds it - calls the LIBOR scandal the “rotten heart of finance”.

When the trust we hold in our banks breaks down, we have no option but to ask our politicians to reinstitute the integrity of the banking system. We await their response.